28JAN09:
Q1-09 DOW: 8900
Q2-09 DOW: 7250
Q3-09 DOW: 5810
Q4-09 DOW: 3960
CITI NATIONALIZED
OBAMA GETS SICK 27AUG09:
Mini Crash 21SEP09 Predicted correctly:
Bailout=Bonuses
Demise of Bear Stearns
Demise of Lehman Bros.
Demise of AIG
Subprime would cause problems
Date of 2007 crash
CRAs were to blame
G20 riots were a party
Northern Rock run
Northern Rock Nationalization
HBOS and RBS demise
UBS really was Useless
Being in Asia this week I have given the FiNTAG newsletter an Asian spin; with a touch of "European" to dampen down my enthusiasm for this part of the world.
Hedge Funds to challenge the Posche/VW takeover in the European Courts?
The FSA confirms what is has been alluding to for ages that children's bonds can now be invested in Hedge Funds?
War - what is it good for? Absolute returns.
Market volatility is dead according to the Chinese.
Porsche looks as if it is pulling a fast one (guardian) The world's most profitable car maker yesterday in effect launched a €35bn (£24bn) takeover bid for Europe's biggest car maker. It will fail, however, and that is the plan - because Porsche's bid price is well below the VW market price. The sports car company doesn't want to acquire the people's car company - yet. At least, certainly not at anywhere near what might be a realistic current take-out price.
So what is that all about? The takeover bid has been prompted by Porsche exercising an option on a 3.6% stake in VW, which will take its stake to more than 30%, the level above which a full takeover bid is automatically triggered.
Under German law the lowest possible bid price is the average over the past three months, or €101 a share: the sort of discount to the current VW share price of €114 that will guarantee failure.
By taking the opportunity to exercise the option which triggers the bid Porsche also won't have to table another formal bid. It can now increase its stake as and when it wishes. Porsche won't even have to tell the market how many shares it owns until it moves above 50%.
So far, so interesting. Except that the chairman of VW is Ferdinand Piëch, whose family controls Porsche.
Like its cars, Porsche has moved fast. Its move came just a couple of days after its supervisory board agreed to raise the stake. Until recently VW was protected from takeover by the 50-year-old so-called "VW law", which limited voting rights and guaranteed the state up to four seats on VW's supervisory board.But last month, after a campaign led by Porsche, the European court of justice indicated that the VW law breached EU rules on the free movement of capital.
If it were happening in Britain - a parallel would be James Murdoch chairing ITV while encouraging his family-controlled BSkyB to build a stake in ITV at less than the market price - investors would be leaping up and down in protest. VW shareholders have a chairman and other board members with Porsche connections. They must wonder who benefits most from the stake-building.
In Germany, though, Porsche chief executive Wendelin Wiedeking, who has hinted he might succeed Piëch at VW, is playing the role of heroic white knight. He insists Porsche is seeking to protect VW from marauding hedge funds, - locusts, as the Germans know them.
German corporate governance, it is clear, still needs work.
Fintag says And I thought Grmany was part of Europe and adhered to best business practice and all those European Directives on open borders, movement of labour and restrictions on anti-competitive behaviour. Obviously not. Still, the good news is that is has opened up a can of worms and us Hedgies could challenge this in the European courts. And for once us Locusts will (b)eat the Germans.
The Financial Services Authority opened the door yesterday for private individuals to invest in hedge funds, scrapping rules which prevent regulated UK investment funds from investing more than 20 per cent of their portfolio in the asset class.
The move is likely to spark a wave of hedge fund launches, which will be easily accessible to the retail market.
Currently, the only simple way for UK retail investors to invest in hedge funds is via a handful of unregulated investment trusts. However, onshore regulated investment funds - such as Oeics and unit trusts - are limited to investing no more than 20 per cent of their portfolio into so-called unregulated alternative investments such as hedge funds.
Only the wealthiest private individuals can invest directly in hedge funds, as minimum investment levels are typically tens of thousands of pounds. Furthermore, individuals also require a special, sophisticated investor licence.
The FSA launched a consultation paper yesterday unveiling its new plans, with the new rules expected to come into effect towards the end of the year.
Dan Waters, the FSA's director of retail policy and asset management, said: "Asset management is a dynamic and innovative industry and we believe it is important that consumers can get access to the latest techniques to manage their own savings and investments.
"We think the time is right to permit access to a wider range of innovative strategies through authorised onshore vehicles. This will allow investors more choice and a better opportunity for risk diversification, while maintaining investor protection through our rules on the operation of the product."
The new rules will include a number of guidelines which fund managers investing in hedge funds will be expected to follow.
The fund management industry, which has been lobbying for a liberalisation of the rules for several years, welcomed yesterday's news. Pryesh Emrith, a hedge fund analyst at Charles Stanley, said: "The proposed new rules place a responsibility on the industry to educate investors about the products, and how they might be used as part of an investment portfolio. It is vitally important that the industry rises to this challenge. A lot of public concern about Funds of Alternative Investment Funds is fear of the unknown. If it is explained to potential investors how these funds are constructed and how they might use them, I believe a lot of their concerns will be allayed."
Nicola Horlick, a fund manager who now runs the investment boutique Bramdean, added her support to the changes.
Fintag says This story has been going on for a while now but suddenly there has been a rush of blood to the head and everyone is talking about it. Just like the Gordon Brown bogey man clip on youtube, momentum reaches a critical point and it becomes a big news story. I looked at the clip when it came out last week along with a handful of other shocked punters. Now it has been viewed by nearly 100,000.
The FSA has been consulting about this for months and it has now been recognised that retail investors should be allowed to access Hedge Funds (using various wrappers of course). The crazy thing is many Hedgies like us have been allowed to sell to Mom and Pop for quite a few years. Problem is we have used a couple of retail banks and raised nothing. Retail investors have no interest it seems. Hedge Funds are still an institutions play but I am sure that soon you will be ticking a box on your pension allocation form that will include exposure to Hedge Funds. I will have retired by then.
There are lots of caveats for these indirect investments (i.e must be through approved and regulated Fund of Hedge Funds) but it has now strengthened my business case that we should list an AIM FoHF.
The SEC should take note. It has adopted another path. Exclusion. No wonder the UK leads the world in Hedge Funds.
Accept peace plan or face war, Israel told (telegraph) The "lords of war" will decide Israel's future if it rejects a blueprint for peace crafted by the entire Arab world, Saudi Arabia's veteran foreign minister warned yesterday.
As leaders began gathering in the Saudi capital, Riyadh, for today's summit of the Arab League, Prince Saud al-Faisal told The Daily Telegraph that the Middle East risks perpetual conflict if the peace plan fails.
Under this Saudi-drafted proposal, every Arab country would formally recognise Israel in return for a withdrawal from all the land captured in the war of 1967.
This would entail a Palestinian state embracing the entire West Bank and Gaza with East Jerusalem as its capital. Every Arab country will almost certainly endorse this blueprint when the Riyadh summit concludes tomorrow. Prince Saud said Israel should accept or reject this final offer.
"What we have the power to do in the Arab world, we think we have done," he said. "So now it is up to the other side because if you want peace, it is not enough for one side only to want it. Both sides must want it equally."
Speaking inside his whitewashed palace, surrounded by luxuriant lawns and manicured flower beds resembling a green oasis in the drabness of Riyadh, Prince Saud delivered an unequivocal warning to Israel.
"If Israel refuses, that means it doesn't want peace and it places everything back into the hands of fate. They will be putting their future not in the hands of the peacemakers but in the hands of the lords of war," he said.
Prince Saud dismissed any further diplomatic overtures towards Israel. "It has never been proven that reaching out to Israel achieves anything," he said.
"Other Arab countries have recognised Israel and what has that achieved?
"The largest Arab country, Egypt, recognised Israel and what was the result? Not one iota of change happened in the attitude of Israel towards peace."
Israel has numerous reservations about the Arab peace plan - which was previously proposed at a summit in 2002. Israel fears any hint that Palestinian refugees would have the right to return to their homes in the event of a peace settlement.
Prince Saud is the 66-year-old son of the late King Faisal. Relieved of the need to seek re-election, he has held office for 32 years.
Flush with oil money, Saudi Arabia is playing a more assertive role in Middle Eastern diplomacy. As well as securing the Arab peace plan, the Kingdom brokered the agreement between Hamas and Fatah - the two Palestinian factions - to form a unity government.
But western diplomats in Riyadh believe this resurgence in Saudi diplomacy stems from more than the kingdom's oil boom.
The menacing spectre of Iran, the rising Shia power with nuclear-tipped ambitions for regional dominance, looms large across the waters of the Gulf.
Saudi Arabia is quietly moving to contain its bellicose neighbour. Prince Saud offered conciliatory words to Iran, laced with coded criticism. "We have no inhibitions about the role of Iran," he said. "It is a large country. It wants to play a leading role in the region, and it has every right to do so. It is an historic country. But if you want to reach for leadership, you have to make sure that those you are leading are having their interests taken care of and not damaged."
Saudi Arabia has privately urged Iran to stop enriching uranium, in compliance with United Nations resolutions and lay to rest any suggestion that it is seeking nuclear weapons. Prince Saud called for a "Middle East free of nuclear weapons" with "no exceptions for anybody, be it Israel or Iran".
Asked whether the kingdom would consider seeking nuclear weapons of its own if Iran managed to acquire a bomb, Prince Saud replied: "We have made it very clear that we are not going down that road under any circumstances."
He paused for a moment, before adding, "under any foreseeable circumstances".
Fintag says War. What has this to do with Hedge Funds? Well not much at the moment, but it is interesting to note that the markets, a bit like Gordon Brown's bogey man youtube clip, have yet to see this as something of interest.
The UK has 15 of its armed forces being detained by Iran, the US is posturing and Tony Blair has said the next path will be unpleasant. With threats that a peace plan not executed properly by Israel will also cause further concerns, I think the markets will soon be reacting.
One can become immune to the middle east, especially as I relax in Singapore, but these events don't feel right. Maybe the US hit the wrong target with Iraq. Iran has nuclear missiles and a very volatile leader who could be adding volatility to the markets very soon.
Market volatility is a good thing for us Hedge Funds but not at the expense of war and destruction. I like inflation and debt uncertainties. Maybe I am getting too sentimental.
Prada defends hedge funds (ft) Michel Prada, president of the AMF, France's stock market regulator, has told Les Echos, the FT's French sister paper, that hedge funds should not be treated any differently from other funds. "It is easy to demonise an idea, which has no precise definition and which has evolved a great deal." His remarks coincide with the decision of the FSA, the UK regulator, to authorise the sale of hedge funds to individuals.
Fintag says That makes me feel good.
ING READY TO FIGHT
ING opens up alternatives (financialstandard) ING's has launched a new capital protected fund through its OneAnswer platform that gives investors access to alternative investments with the comfort of built-in safeguards.
Developed exclusively for ING by Société Générale Asset Management (SGAM), the ING SGAM Protected Alternatives Fund will give OneAnswer clients exclusive access to a globally diversified range of investments, including long-only US equities, long/short European equities and a multi-strategy hedge fund - all with the comfort of rising capital protection.
The fund ensures 80% protection of investments, rising in line with the underlying assets. If the fund reaches a new high watermark, the underlying assets are protected at 80% of that higher level.
David Kan, ING's Head of Product & Strategy, Personal Investments, said the new fund is tailored to meet the needs of advisers who are increasingly using or recommending alternative assets for their clients.
"Clients are becoming more sophisticated, and there is demand for different tools and products to suit different age brackets and different needs,” Mr. Kan said.
“For many investors, particularly those approaching retirement, this will provide potential capital growth, as well as peace of mind.”
Almost a third of Australian super funds now invest in alternative investments, and internationally, alternative strategies have outperformed traditional global equities, with less volatility.
The investment complements ING's other capital protected product, the ING Protected Growth Fund, launched in December last year, which has been well received.
Fintag says Interesting? Not really. But it does show the continuing industrialisation of Hedge Funds. Boutiques are dead. Long live the prop desks at the big banks.
Just a few weeks have passed since the Dow Jones Industrial Average took a 416-point plunge on Feb. 27, for its sharpest one-day drop in four years.
Yet approaching the end of the first quarter of 2007, U.S. stock market indicators stand within a percentage point or two of where they began the year. The average stock or bond mutual fund has posted a modest gain since New Year's.
Through the end of last week, Bloomberg data show the average long-term fund with a net advance since Dec. 31 of 2.2 percent. Stock funds have gained 3 percent, bond funds 1.4 percent.
It used to be that after a bombshell day like Feb. 27, you would feel the fallout for months. Dangerous at it may be to say, something must be different this time.
Two broad explanations present themselves. The first is that the economy itself is healthier and more stable than most modern investors are accustomed to, with strong worldwide growth and relatively benign conditions in inflation and interest rates. The second is that the markets themselves have grown more efficient in the hands of the biggest and best informed population of investors the world has ever seen.
Everybody frets as much as ever about inflation and recession -- and both perils constantly warrant investors' respect. Even so, the inflation we are concerned about in the U.S. is running at 2.4 percent, as measured by the latest monthly year-over-year change in consumer prices.
That's less than a percentage point above where the Federal Reserve would like it to be -- and scarcely more than half the 4.1 percent average rate over the past 50 years. In the bond market, notoriously sensitive to inflation, the interest yield on 10-year Treasury notes sits comfortably at a kind-and-gentle 4.6 percent.
Recession? We've had but one of those in the past 15 years, and even that one didn't last long. While U.S. growth may dip this year to 2 percent or even below, the pace is far stronger in many other parts of the world. "In this decade, global economic leadership has been transferred to emerging economies," says James Paulsen, who oversees US$175 billion as chief investment strategist at Wells Capital Management in Minneapolis.
The markets themselves, meanwhile, have traveled a learning curve. In the US$10.6 trillion mutual-fund industry, few managers trouble themselves any more to try to time the markets by moving in and out of stocks. They stay fully invested, and focus on picking companies one by one.
Their 96 million clients likewise have given up the timing game, and are pretty much content to keep feeding in contributions to their 401(k) plans month after month.
Another fast-growing group, hedge-fund managers, has emerged in recent years in pursuit of rapid short-term trading objectives. There is much evidence, however, that the hedge funds' quest has perversely reduced the very volatility on which they thrive. By intensely seeking out inefficiencies, they have made the market more efficient.
The appeal of these two explanations, economic and financial, for reduced volatility is only enhanced by the neat way they fit together. "What is wrong with a low (market volatility) anyway?" Paulsen asks. "Might it simply reflect an economy which is less volatile than average and therefore more predictable?"
Now, no good thing ever happens in economics without raising at least twice as many problems and questions. Low volatility can be a serious symptom of complacency, which like pride often goes before a fall. And low volatility makes life harder for investors, by reducing the supply of bargains to buy and squeezing returns available to meet such relentless liabilities as pension and retirement costs.
Either complacency or low returns, or both, can drive investors to take extra risks. Over time, this increases everybody's vulnerability should something go wrong, sending shock waves through a system that isn't prepared.
All of which may help explain why so many people in the markets were happy to see the return of volatility on Feb. 27, scary though the day's experience may have been. Trouble is, those same people went and spoiled the game by immediately starting to smooth things out again.
Fintag says War? Debt Crisis? Over valued Assets? Pirates strip, ripping and raping companies? And the markets turn a blind eye. I am not so sure but then nobody can be sure what the markets will do next. Strange times we live in but we always revert to mean.
Just like King Knut we cannot hold back the tide. Unless you build a large wall of course.
SAVED
Ritchie Capital rescued by rival (financialnews-us) Troubled hedge fund Ritchie Capital Management is selling off assets from half of its flagship multi-strategy fund and has negotiated a cash injection from a rival to create a new company.
Ritchie Capital, a US hedge fund manager, has been trying to sell the assets in its flagship multi-strategy fund since December after deciding not to go ahead with a restructuring. Ritchie has entered into a $1bn (€749) deal with Reservoir Capital representing half of the assets from its flagship fund, according to a source close to the firm.
The deal offers investors who wish to opt out of Ritchie's fund 50 cents on the dollar, half of which would be paid after the deal is finalized and the rest to be paid over a three year period. A company source said that if assets perform, the deferred assets investors will get back could range from 80 cents to 110 cents on the dollar.
Ritchie investors have until Friday to approve a deal.
The investment from Reservoir will be used for a new fund called Rhone. Although the new company is a joint venture between Reservoir and Ritchie, it will be managed by Ritchie.
Ritchie is still in talks to sell other assets, according to the source. In December, Coller Captial, a UK-based private equity secondaries specialist, was in negotiations with Richie. The deal would have been Coller's first step into hedge funds.
In addition to the remaining half of the flagship fund, Ritchie continues to run other strategies such as Ritchie Risk-Linked Securities, Ritchie Real Estate, Ritchie Asia and Ritchie Quantitative Strategies.
In January 2006 Richie sold its life sciences debt financing unit Ritchie Technology & Life Sciences Finance, founded in 2005, to BlueCrest Capital Finance in order to raise capital to meet investor redemptions.
The company, which was founded by Thane Richie in 1997, a former football player turned trader, is based in Chicago.
The firm has been trying to reconcile the conflicting wishes of its investors after it decided two years ago to make private equity investments from its flagship fund. As investors began redeeming their funds, the firm refused to sell some of its investments at a loss to meet these requests.
Richie was also stung by losses on investments in a volatile energy market in the wake of Hurricane Katrina in August 2005. Ritchie decided to sell its flagship fund after determining it was impractical to implement a restructuring.
Fintag says Fingers crossed.
ANYONE FOR TEA?
Hedge funds clamour for China shares despite curbs (economictimes) HEDGE funds are hungry for a bigger bite of China's booming but restrictive stock market, undeterred by last month's gut-wrenching one-day selloff and limitations on their access and trading strategies.
Mainland shares soared 130% last year, reversing a five-year losing streak and drawing global investor attention. But Beijing has only granted Qualified Foreign Institutional Investor (QFII) quotas of $10 billion, mostly to major banks, which can make that quota available to money managers.
Hedge funds, which aim to generate returns in both bull and bear markets, are putting pressure on their prime brokers to get them more access to mainland-listed A-shares, as they see both near-term trading opportunities and long-term prospects.
China's ban on short-selling - a practice typically used by hedge funds to make bets on shares falling - has not prevented foreign managers from investing in A-shares. “Would I like to invest more in China A-shares via QFII? Absolutely,” said George Long, chairman and chief investment officer of Hong Kong-based hedge fund manager LIM Advisors.
“That said, the easy money has been made. Are there opportunities still? Absolutely.” Long's firm manages $820 million in assets, including about $25 million invested in A-shares.
China's benchmark Shanghai composite index spent much of early 2007 setting new record highs until a nearly 9% plunge on February 27 that helped trigger a global market slide.
While the plunge spurred many investors to sell, it proved a boon for more risk-tolerant hedge funds who bought on the dip as the market has shot back to fresh highs. “After the 27th of February, the Black Tuesday, we got a lot of recycling of the QFII, which I am very happy to receive,” said Yang Liu, managing director with Atlantis Investment Management. “From that day until today we made a 20% return already,” she added, noting that gaining access to QFII quota held by banks had once again become difficult.
Chinese officials have indicated the total QFII ceiling quota will eventually be raised again, but have given no clear indication of the timing or size of the increase. The existing $10 billion quota has been almost entirely allocated.
Fund managers and prime brokers, who service hedge fund clients, said QFII demand marked a major shift from two to three years ago, when the Chinese market was in the doldrums. “We continue to see strong interest in China, although demand has calmed down a bit recently,” said Tim Wannenmacher, head of Asia capital markets prime services for Lehman Brothers.
Prior to the February 27 drop, Merrill Lynch was getting five to 10 requests per day from hedge funds looking for additional QFII access, with Harvey Twomey, head of Pacific Rim sales for the bank's global markets financing & services team, calling their appetite 'voracious.'
Hedge funds are buying into the market even though they are forbidden from using one of their favourite tools: short selling. This allows them to borrow stock and sell it, hoping it will fall in value so they can buy it back cheaper and book a profit.
Managers are trying offset the A-share shorting ban by shorting the shares of Chinese companies listed in Hong Kong, or the China Enterprises index of H-shares and the iShares FTSE/Xinhua A50 China Tracker fund. But Lim's Long said the ability to short A-shares is not the key consideration for many managers.
“If you're a serious investor, you would want to have some participation if for no other reason than to learn from the market,” he said. “There is no question China will become a major capital market.”
Fintag says This is why I am in Singapore right now and China later this week. It is tough but not impossible to break into China although I personally still believe that India will a better bet.
WHO IS THE DADDY?
Buyer beware: Liquidity risks are real (bangkokpost) Thailand is usually referred to as the Land of Smiles, but to stock market investors it has recently been the Land of Frowns. The only bit of relief is that global stock markets are performing even worse.
Significant price reversals often seemingly come out of nowhere. While it is entirely rational for global markets to see a correction after the bullish exuberance since last summer, what might have looked irrational was how quickly the sharp declines took place. The 9% fall in the Shanghai market in late february was followed by a 416-point slide in the Dow and a very sharp correction in India's Bombay Sensex. Most other markets followed suit.
Some have argued the catalyst for the major sell-off was Alan Greenspan, the former chairman of the US Federal Reserve. But it's unlikely that his obvious statement that the US housing slump could possibly cause a recession was news to anyone.
What made the market so vulnerable to panic? It wasn't so much a matter of irrational exuberance _ to paraphrase Mr Greenspan _ as it was a matter of irrational complacency.
I found it unsettling that the Chicago volatility index (VIX) soared 70% in one trading session. This violent spike showed the degree of interconnection among leverage, risk and volatility in global financial markets.
This is only natural in a world where 10,000 hedge funds control more than a US$1 trillion in a daisy chain of leveraged hot money. According to the Bank for International Settlements (BIS), nobody knows how big the carry trade really is. Estimates based on the short-term net foreign lending of Japanese banks put the carry trade at only US$200 billion. But hedge funds need not borrow yen. Instead, the carry trade is typically done through transactions, such as currency forward swaps, that are off the balance sheets and therefore do not show up in official statistics.
If liquidity indeed is the magic word that drove the bull market, please also remember this axiom: ''Liquidity tends to be like a taxi on a rainy Friday night; it disappears when you need it the most.''
When asset prices suddenly fall very sharply, liquidity can dry up faster than you can call your private asset manager to sell your investments.
Emerging-market investment is one area where investors are making a trade-off between low liquidity and potentially higher returns. Liquidity risk, however, is real, especially if and when fear spreads. The carry trade tends to break down when markets become more turbulent. In such conditions, those who borrowed yen at very low interest rates to buy other riskier assets such as emerging market equities might face a double blow as the yen surges and other assets fall.
After Russia's default in August 1998 and the subsequent collapse of the now infamous Long-Term Capital Management (LTCM) hedge fund, traders and investment banks sharply reduced their leveraged positions and the yen rose, forcing those who had borrowed yen cheaply to cover their positions. The yen jumped 13% within three days and led to the collapse of LTCM, which had two Nobel Economics laureates overseeing risk management.
If the turbulence is sufficiently large, many years of profits from the carry trade could be wiped out.
The head of products and services of a major private bank in Singapore told me the other day that it had tried to launch a conservative investment product and nobody was interested. Another bank's investment chief proclaimed: ''I am paid to be bullish''. Often the writing is very clearly on the wall, but none are so blind as those who refuse to see.
The optimists argue that Wall Street trades at a valuation not much above 14 times earnings at a time when Fed chairman Ben Bernanke can respond to weak data with ease, private equity has billions in uninvested cash, the capital-expenditure cycle is only beginning, and so far the only sector experiencing financial stress is the US subprime mortgage borrowing market. Of course, homebuilding, mortgage brokers, autos and commercial banks are no-no investments as long as the US Treasury yield curve remains inverted, and the Fed does not ease its monetary policy.
The pessimists argue that de-leveraging and the unwinding of the carry trade will set off a major chain reaction of defaults and bankruptcies, The big steamroller, they say, is just around the corner. The major global sell-off you witnessed in the past few weeks could just be a preview of coming attractions.
Those who consider rushing in to buy on dips please remember that bottom-fishing is notoriously difficult and one of the most expensive sports in the world. Buyer beware.
Fintag says Another viewpoint. I love Asia. Opinions are strong and risk is king.
Wellington, a vice president at Dimensional Fund Advisors Inc., flashes slides of magazine headlines such as ``The Next Microsoft'' and ``Tech Stocks, Everyone's Getting Rich.'' Investors who read this stuff and scour stock research are deluding themselves, he tells the packed conference. DFA, which manages $123 billion, doesn't worry about what a company does or how much money it makes before buying its stock.
``We walk in blindfolded,'' Wellington says.
Wellington and his colleagues at Santa Monica, California- based DFA preach that no one can predict which way stock prices will go. Their creed is rooted in the efficient-market hypothesis espoused by economist Eugene Fama. A University of Chicago finance professor and DFA director, Fama, 68, maintains that securities prices reflect the collective wisdom of all the participants in a market. Active investors -- people who actually pick stocks -- rarely beat the market over the long haul, his theory goes.
To spread the word, DFA has recruited a small army of more than 500 independent financial adviser firms. The acolytes who work for these outfits are one of the biggest, and least-noticed, reasons why DFA's assets have almost quintupled in the past decade.
Changing Tack
DFA ignored individual investors for the better part of its 26-year existence in favor of pension funds, corporate accounts and other big institutions. Now, the firm is going in the opposite direction. DFA gets more than 60 percent of its assets from individuals these days compared with 43 percent five years ago.
Money is pouring in. DFA ranked fifth among U.S. fund groups in raising money, with $14.4 billion in total new funds through December, according to Financial Research Corp., a unit of Roseland, New Jersey-based Bisys Group Inc. DFA has accomplished this with almost no advertising except for running a dense, graphically challenged Web site. The firm hired its first marketing officer in January.
Consistent with Fama's theories, DFA is agnostic about which stocks it buys. Its fund managers do little or no company research. They don't schmooze with chief executives or dial in to earnings conference calls. DFA managers are devotees of quantitative analysis, or quants, who put their faith in financial theory, rather than human judgment, when deciding what to buy or sell.
Bloopers
So committed is DFA to passive investing that it hangs stock certificates of bankrupt companies it has ended up owning on the wall of a trading floor break room. When reporters call about any of the 500 companies in which the firm shows up as a 5 percent or greater shareholder, Wellington pleads ignorance.
Unlike traditional index fund managers, which buy all of the stocks in, say, the Standard & Poor's 500 Index, DFA tries to capture an entire asset class -- small cap or value, among others -- with the purchase of huge, seemingly indiscriminate, swaths of stock.
Instead of buying all of the stocks in an index devised by someone else, DFA defines each asset class itself, based on companies' market capitalizations and book-to-market ratios, or book values relative to market values. The firm weeds out the stocks that aren't traded much because those shares are relatively expensive to buy and sell.
DFA US Micro Cap Portfolio, the company's flagship fund, holds 2,442 stocks out of a possible universe of 2,487 companies worth less than $500 million. DFA's 99 percent exposure to the microcap market virtually makes it the market itself, at least according to Morningstar Inc.'s Ibbotson Associates, which uses the returns of DFA's Micro Cap fund to illustrate the returns on small company stocks from 1982 to 2006.
`Fatal Error'
Thomas Nugent, chief investment officer at PlanMember Advisors Inc., says DFA made a ``fatal error'' early in its history by focusing on these microcap stocks, the bottom 10 percent of companies by market value. ``Companies in bankruptcy pass through the 10th decile before they go bankrupt,'' he says.
While Nugent says he's a fan of DFA and a longtime acquaintance of DFA co-founder David Booth, he prefers the methodology of New York-based WisdomTree Investments Inc., which pitches exchange-traded funds based on earnings, dividends and other non-market-cap weightings.
Morningstar awards DFA's oldest fund, US Micro Cap, three out of five stars. The fund has been burdened by ``greater volatility than most of its peers,'' Morningstar says. Morningstar analyst Sonya Morris, in a separate report on the fund, dubs the fund a ``fairly racy offering'' that has ``experienced its share of turbulence'' and is more volatile than 80 percent of similar funds.
Wall Street Debate
Which approach is best, active or passive investing, is a never-ending debate on Wall Street, where passive indexers such as DFA and Vanguard Group Inc. are the antithesis of celebrity stock pickers. If there's any criticism of indexing, it's that as goes the market, so go the indexes, which can lead to losses unless an investor also invests in active funds to mitigate the market swoons.
The indexers have been winning lately. According to the Standard & Poor's Indices Versus Active Funds Scorecard, which tries to add substance to the debate, the S&P 500 Index beat both actively managed large- and small-cap U.S. stock funds last year. The index topped 69.1 percent of large-cap funds, while the S&P SmallCap 600 Index led 63.6 percent of small-cap funds. The indexes posted similar results for the past three- and five-year periods.
Dimensional's $8.8 billion DFA US Small Cap Value Portfolio holds shares in 1,313 companies, a portion of the firm's entire store of some 11,000 stocks. The fund posted a total return of 21.6 percent in 2006. Fidelity Investments' equivalent $1.27 billion Small Cap Value Fund, which invests in 181 stocks, returned just 15.6 percent. The MSCI U.S. Small Cap Value Index gained 16.9 percent.
DFA Club
Dimensional is selective about who it lets into the club. Individuals can invest only through independent financial advisers. The advisers responsible for the firm's recent success have to pay their own way to attend mandatory conferences, where they're treated to lectures by the firm's roster of academics and directors, including Fama and Kenneth French, a finance professor at the Tuck School of Business at Dartmouth College, who helped Fama refine the efficient-market theories in the 1970s.
Booth and DFA co-founder Rex Sinquefield were early pioneers of index investing. Booth learned the trade at the feet of John McQuown, a DFA director who helped develop the first index fund in the late 1960s. Sinquefield's DFA biography says he ``virtually invented index investing'' while at American National Bank of Chicago in the early '70s.
When Booth and Sinquefield founded DFA in 1981 in an apartment in the Brooklyn Heights neighborhood of New York City, they initially avoided taking money from individuals, who often chase flavor-of-the-month funds.
Courting Investors
Instead, the firm preferred the relative stability of institutional money. Early investors included International Business Machines Corp., McDonnell Douglas Corp. and Owens-Illinois Inc.
In the late '80s, a financial adviser named Daniel Wheeler, now 62, convinced Booth and Sinquefield that pooling together his 15 individual investors would provide the stability of a small institution.
It helped that at the same time Wheeler was banging on Dimensional's door, Charles Schwab Corp. was creating its Schwab Institutional unit, which handles the back-office work for about 5,000 independent financial advisers. The Schwab service made it easier for advisers to sell funds like DFA's.
Impressed by Wheeler's persistence, Booth and Sinquefield gave him a one-year contract to attempt to build a financial advisory business.
Tough Going
It was tough going at first. Wheeler got Schwab to put up some money in the summer of 1989 to stage an eight-city, two-day series of seminars for the benefit of accountants and independent investment advisers. He sent out 40,000 invitations and rented out conference rooms that could accommodate up to 300 people.
``I thought this would launch it in a big way,'' Wheeler recalls.
All of 42 people showed up.
``Fortunately, that didn't kill the deal,'' says Wheeler, a former Marine Corps officer who studied the efficient-market hypothesis while pursuing a Ph.D. (which he never completed) at the University of California, Berkeley.
Chalking up the fiasco to a failure to articulate the message, Wheeler went back to the accountants with the promise that DFA could deliver the return investors expect, which resonated with advisers fearful of antagonizing clients. By the end of that first year, Wheeler managed to bring in $70 million from advisers.
It didn't help Wheeler's task that the firm, even in its infancy, threw out any advisers who purported to be able to time or beat the market. Wheeler, now a DFA vice president, proudly recalls the tale of overhearing a visiting financial adviser indiscreetly boast in DFA's elevator of working with a big market timer.
Parallel Universe
``I said, `What are you doing here?''' Wheeler says. ``I said, `I'm sorry, you're not welcome here. You're not invited. I want you to leave.'''
Dimensional has become cozy enough with the financial advisers that it now vets potential new funds with them.
``The institutions don't have the same kind of clubbiness with us,'' Booth, DFA's chief executive officer, says. (Co-founder Sinquefield retired in 2005.) ``They think they may have to someday fire you.''
Many of the advisers travel in a parallel universe where the rest of the world seems to be completely out of its mind.
`Lure of Quick Riches'
``I'm beating my head against a wall saying, how can we have all these people doing all this trading?'' says independent adviser and Dimensional convert Mark Hebner, who once issued a press release calling active money management a ``hoax.'' ``It's the lure of quick riches, the lure of an easy buck, like gambling.''
Hebner's Index Funds Advisers Inc. has become one of the leading proselytizers for DFA. Hebner oversees $795 million, all of it invested in DFA funds.
``I went through their program in June 1999,'' Hebner says. ``It was an epiphany, like a defining moment when you cross over and really understand what's going on.''
While DFA itself shuns most forms of self-promotion, its corps of financial advisers serves as a tireless source of propaganda. Much of it consists of contempt for active investing and the financial media that it says dupes the public into thinking anyone can beat the market.
Typical is something called Tribeca Financial LLC of Mesa, Arizona, whose ``7 Deadly Sins of Investing'' brochure starts with the sin of active investing and includes ``stock picking'' and ``investment porn.''
DFA Converts
Overcoming the deadly sins involves ``investing with a diversified portfolio of low-cost index funds,'' preferably DFA's offerings that just happen to be sold by Tribeca.
Few of DFA's advisers can match Hebner when it comes to the sheer volume of words produced on behalf of the firm.
Weighing in at 392 pages, Hebner's recent self-published tome about index funds equates active investing with alcoholism. With numerous pages devoted to DFA, and just as many spent bashing active managers, the book amounts to an unpaid ad for the company.
``Here they have the best product on the planet and hardly anybody knows about it,'' Hebner says. ``I've always had a skill for communication.''
If anything, the passing of time has only hardened Wheeler and DFA's stance against the scourge of advisers who dabble in active investing. Early on, Dimensional didn't offer enough diversification in the asset classes of its funds to allow advisers to put all of their eggs in the passive basket. With 61 funds today, inclusive of U.S. and non-U.S. equities as well as fixed-income funds, there's no excuse for an adviser to stray from DFA when deciding how much money to put into various passive funds.
Hazing Recruits
To ensure advisers hew to the DFA line, prospects first have to submit a plan detailing how they'll sell DFA funds to their clients. Then Dimensional pays a visit to the financial adviser's office.
``They really put us through the wringer,'' says Michael Davis, whose Resource Consulting Group of Orlando, Florida, manages more than $1 billion for 315 clients. Among other things, he had to show DFA his Form ADV, a Securities and Exchange Commission filing that asks financial advisers whether they've ever been convicted of a felony to whether they've been sued.
``They asked for our business plan, what is our niche, how we get clients, how we retain clients, what is our business model,'' Davis says. Does he get such scrutiny from other fund companies? ``Are you kidding? Most investment houses say, `Just send us the money,''' he says.
``We can tell what their level of commitment is,'' Wheeler says. ``We have to screen them to find out if they're coming with views consistent with ours.''
Lessons From Fama
After passing the sniff test, the adviser is then required to attend a mandatory, two-day seminar at his or her own expense at DFA's Santa Monica headquarters. ``We don't even give them pens,'' Wheeler says.
Fama and French usually make an appearance, presenting slides of tables of historical stock data to prove their point that the market knows best. At a January introductory session at DFA's oceanfront headquarters, presenters included Fama and his son Eugene Fama Jr., a DFA vice president whose job includes translating his father's theories for human consumption.
Fama Jr. livens up one morning's proceedings with a sense of humor that is the antithesis of the serious demeanor of his father.
``Saying my dad is a finance professor is like saying Michael Jordan is a basketball player,'' he deadpans. ``He's really the father of modern finance. But that doesn't mean I'm modern finance.''
Excitement Elsewhere
Michael McClain, who helps oversee the $600 million asset trust department of Jefferson Bank in San Antonio, ended up at the conference after becoming disillusioned with the returns of active management.
``People want me to not find their money exciting,'' says McClain, referring to DFA's passive-investing philosophy. ``They want me to find excitement elsewhere.''
Once they've survived the hazing, the financial advisers are policed by other advisers to ensure they don't dabble in active investing. DFA converts keep tabs on other advisers to make sure they toe the line.
``Eyes and ears are out there,'' Wheeler says. ``We'll give that adviser a call and say, `You can't do that.'''
``They insist on educating you,'' says Brenton Kessel, a Pacific Palisades, California-based financial adviser who deposits a large chunk of the $550 million his firm oversees in DFA funds. ``Once you get their brand of education, you can't drink the rose. It's either red or white.''
Like many DFA acolytes, Kessel, 38, admires the firm's belief in the power of markets over individuals. ``I'm very numerical, notwithstanding the touchy-feely,'' says Kessel, referring to his passion for yoga.
Hebner says it's really the rest of the world that's off its rocker. ``People say it's like drinking Kool-Aid, that we're in a trance,'' says Hebner, who is shown wearing a cheesehead hat on his busy Web site. ``That's a bunch of BS. All we did is become educated, and everyone who is doing active management is not.''
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