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January 2, 2007

Research Pricing

Posted in General, Public Markets Investing, Securities Research
by David Teten @ 11:09 pm —

I enjoyed participating in AQ Research’s recent conference on “The Future of Research”, last December 5. I finally had a chance to edit and post my notes on the panel on Research Pricing.

Lisa Shalett, Chairman and CEO, Sanford C Bernstein
Paul Spillane, CEO, Soleil Securities
Chair: Albert Alonzo, AQ Research

Lisa Shalett:
If research is really a discrete model, you could say that should have a fixed price.
But I believe research is actually really an advisory service, an interaction, part of a broader process—-part of the mosaic of ideas. No money manager on the planet will say he has just one source for investing.
Research should be priced in direct proportion to the value creation or value destruction. By comparison, money management industry prices its service in proportion to its own value creation or value destruction.
Unbundling and transparency are two separate concepts. The idea that research pricing should be tied to volume or fixed is another concept. I believe strongly that research should be tied to volume.

Paul Spillane:
For us to be successful, we have to determine a fee.
We are the only part of the finance business that provides product for free.
I don’t want us to be paid based on our stock-picking performance.
1-2 fund managers, and a batch of hedge funds, have given us a price schedule: you bring in a company manager, I’ll pay X. you provide an expert, I’ll pay Y. you set up road show for me, I’ll pay Z.
We’re trying to ascertain value of what we provide.
Our analysts only get paid if customers say, “Pay them”. It’s all client-directed.

Independents have always been transparent, but sell-side have dragged their feet in complying with menu pricing.

Trading commissions should be going down slowly. There’s no reason why they should be flat or rising. The wool is being pulled over the money management industry’s eyes. Marginal cost of executing /clearing a trade is close to zero, and Sanford Bernstein is not even a scale player in this business. If you want to save money on research & trading, start there first!

If you’re head of research at a bulge-bracket bank, you focus your effort on minimizing outliers, so no one can sue you. You’re not focused on creating alpha.
Money management industry is afraid to say what they’re paying for research.
If a money manager says it’s paying 2 cents for research someone can sue. But if you say you’re spending it on execution, it’s harder to complain about it. Look at Jefferies settlement.

Broader public policy question: what does research provide?
Buy side says they’re paying for liquidity, for there to be a dialogue.
Trading cost curve has gone down 6 pct. annually since 1975, to 3.5 cents now.
The regulators want you to be democratic, give access to everyone. Pricing mechanism should be scale neutral, to not overly advantage the largest money managers.

Why do indies still get paid so much less than sell-side?

Because we let them!
We don’t know what we should be charging.
We don’t have enough senior-level relationships.
We don’t know if we’re being overpaid or underpaid.
You have to be willing to walk away from underpayment.

We don’t put a formal price on our services. But we use the concept of fair share. We use polls, Greenwich polls. We’re paid 1/3 of what we should be paid, if you compare our ranking in polls with the total payments to research providers. That hasn’t changed in 13 years.
The reason is that the sell-side has a lock on being systematically overpaid.

Lisa, you have the power to change this. Just shut them off.

We’d shut them off if Thomson would implement the change to make it easier to shut people off. (laughter)

What would it take for you to get out of execution?

It will only happen if we can be confident that we’ll get paid 3x what we’re paid now.
In Europe, implementing CSAs as follows: 8 bps for execution, 7 bps for research, plus 2 bps for proprietary research when paying sell-sides. These sell-side firms are holding the indies’ money for 90 days, paying no interest.
If there were a DTC, a Switzerland, for these commissions, I’d join it and exit trading. But I don’t believe in what’s being implemented today.

CSA gives firms freedom to use traditional payment mechanism.
Is now the right time to push on pricing?

Depends partly on extent to which funds are generating substantial alpha.
Hedge funds are willing to pay unlimited amount for good research.

How do you get a return on capital that you can’t measure?
If someone could provide a utility function for research, big banks would sign up and then focus on prop trading.
We’re entering dangerous part of cycle, because we’ve had good returns for several years. This is first year in 10-15 yrs when more hedge funds closed than opened. So it’s a tough time to talk about pricing.

Big banks are generating 30% ROE. They’re good businesses.

Will we see a more level approach between pricing of sell-side and indie research?

We won’t move to unbundling until we’re forced to.
We won’t subject ourselves to the soft dollar pool, which is only 7-15% of giant pool of commissions ($14-$15B in US). I don’t want to be in the kiddie pool.

Barry Hurewitz (Morgan Stanley):
We have 500 analysts . Average buy-side person with a $50M commission pool has 11 buy-side analyst. Lisa might have highest per-hour price on the Street, today. I don’t see why you can’t just price your services explicitly; that’s what we do.

Shalett responds:
From 75 to 2000 (decimalization), trading was a commodity, because market was very concentrated. Most volume going thru NYSE specialists, whether it came from MS or GS, or it was OTC (fulfilled by market-maker).
Post-2000, you had fragmentation of liquidity, which meant differential execution quality. Trading has become a more differentiated product. Capital commitment actually mattered.
Now, pendulum is swinging back. Technology is reconcentrating liquidity. Buy-side can trade directly with the market. Vast majority of executions are commodities, or will be in next 2 years. So prices should be going down. It doesn’t make sense that prices go up.
CSAs favor some players over others.
Macroeconomics don’t stand up to scrutiny, and industrial behavior is being perverted as a result.

Morgan Stanley can’t price by the hour, because there are too many constraints. Customers aren’t willing to set a price. There are way too many internal pressures calling your #1 ranked analyst to come to a meeting, go to a conference, etc., to say simply that he bills at $3000/hour.

Making Investment Research Pay

Posted in General, Public Markets Investing, Securities Research
by David Teten @ 11:03 pm —

Following are my rough notes from AQ Research’s recent conference on “The Future of Research”, on December 5.

The speakers on this very strong panel were:
Scott Lessing, Chief Operating Officer, Citigroup Investment Research
Shubh Saumya and Jai Sinha, Partners, Booz Allen
David Weild IV, CEO,The National Research Exchange

For more information on Booz Allen’s views on this subject, see their report, Saving Sell-Side Research.

This question [of how to make investment research pay] is less pressing than it used to be 2 years ago. We’re coming from a great year for our clients and research.
There’s been a shift towards payment for quality of research

Jai Sinha:
News of death of research was greatly exaggerated.
Components of value of research include distribution and service, as well as actual content.
Any time commissions are not explicit, there is waste.
We don’t need to necessarily force change in the model

Quality is in the eye of the beholder. What is quality to an actively traded hedge fund isn’t necessarily quality to a longer term account or a public company. I noticed Monika Schulz with Wall Street Letter in the back. She recently conducted an interview with Candace Browning, the Director of Research at Merrill Lynch. Candace, when asked how the research product had changed, responded that it has become more “trading focused.” It’s clear that public companies are having a tougher and tougher time getting the support that they need from the largest sell-side firms to reach long-term investors. These accounts don’t generate enough commission volume to merit much attention yet they are the most important accounts for CEOs to reach. As a consequence, more firms will need to ensure aftermarket support themselves.

Let me share one interesting anecdote: I was talking with the CEO of $350-$400M Australasia-based company. A bulge bracket firm was taking this CEO on an all-expenses paid roadshow in New York and Boston to see institutional investors. This CEO couldn’t believe his good fortune and asked me “Why?” I asked him to share the list of accounts he was visiting and it was clear that most of these accounts (e.g., Tiger, SAC, Goldman Sachs Principal Strategies) were so large as to likely be prohibited from owning a stock of his market capitalization. The CEO went on to say that all of his conversations focused on industry trends and not his company – a clear sign that they were mostly wasting his time.

We recently did a project for a $750M VC. They were working with a $500M company going public. The bank with whom they were talking about going public didn’t have coverage on even one company with a market cap under $1billion. While I might choose that firm to take me public, I sure need to be careful about who is going to support my “little” company in the aftermarket.

We cover 3000 stocks. We’ve been expanding small/mid-cap stocks.

We run one funny analysis. We look at daily volume per analyst per stock. This analytic shows that if you cover a firm within Dow 30, you’re still competing for more volume/analyst than smaller cap stocks. In fact, the median Dow 30 stock generates about 300,000 shares of volume per analyst per day, which drops to about 90,000 shares per analyst per day for the median stock in the S&P 500. Compare this to the NASDAQ Composite, which is more actively traded than the NYSE Composite, and the median stock generates only about 30K shares per analyst per day. This is partly the reason why if you’re analyst #30 on IBM, you’re still competing for more volume than analyst #2 on a mid-cap stock. A rule of thumb is that you are generating about $0.01/share/day available to research. The balance is siphoned off by program trading and low cost algorithmic trading.

Thus, despite the fact that accounts reject the need for more “maintenance research” on large cap stocks, the fact is that the stocks are so broadly held and generate so much volume per analyst that the economics are compelling.

Volume of trading doesn’t drive our coverage decisions; it’s investor interest. In addition, there is very little correlation to an idea that we generate and how we get paid. We can get paid in IBM trades for a small cap idea.

Yes, but investor interest tends to be correlated to trading volume. Plus, your definition of small cap is apt to be higher than ours. We’re looking at sub $500 million market cap companies and Citi is probably closer to $750 million and larger.


Unbundling will allow people to pay differentially.

there’s room for many different payment models. We’re very adaptable in how we get paid.
Greenwich Associates surveys say that 20-60% of commissions are allocated to research, and rest is execution (capital commitment, execution services, etc).
I suspect that FSA data will be roughly comparable.
We’ll hold on to a larger percentage of this pot than competitors, and it’s because our quality is higher.

The more street-dependent buy-side firms will allocate a larger percentage to research.
I see a hollowing out of the middle, of the 35th person providing IBM coverage.

Citigroup provides a whole host of products and services that the independent firms don’t – equity derivatives, enormous sales trading, algorithmic trading (Citigroup bought Lava Trading not that long ago), securities lending, and Citigroup is the #1 underwriter of equities globally. Citi has a great portfolio of services that go beyond simply research and that gets reflected in commission payments.

There is aligning of consumption with spend

We have a discussion with client about what resources we can commit to them; what % of payment pool should be sent to them.

Audience Question:
What threats can you make? I had a client say, “Show us what you’re giving us. If you don’t have that, how can you tell us what you’re going to take away?”

We have 3000 accounts. There were 4 contacts at one particular account who were heavy users of our research. They were the people we needed to upsell.

Tiers are binary: you turn it on or off. If you want research to be a profit center, how do you do that?

How often is there a mismatch of clients who are dramatically underpaying?
One of our clients asks, ‘What is the research product?’

We don’t talk about resources cost in dollars per hour. We talk about where the client ranks with us, and say we believe you’re underpaying.

November 29, 2006 How to increase your consulting revenue and your profile

I had lunch recently with David Jackson, CEO of SeekingAlpha, and a former neighbor of mine. I thought that many of our Circle of Experts would benefit from contributing to David’s company.

Briefly, is the leading blog source of stock market related commentary by money managers and industry experts and a major provider of financial content to Yahoo! Finance. Articles published on Seeking Alpha reach over a million readers per month, about 17% of whom are finance professionals. Crucially, each article published by Seeking Alpha (including those syndicated on Yahoo Finance) contains a link to the author’s biography or URL of choice, and can therefore be used to publicize your availability for consultations via Circle of Experts. If you are already writing any sort of analysis, there’s no marginal cost or effort to you. Just send SeekingAlpha your work, and they’ll do all the editing and production for you.

You can read about Seeking Alpha at, view a list of sample contributors at, and submit an article for publication (Seeking Alpha’s editors will contact you directly after doing so) at or by emailing Mick(at)

(As disclosure, Nitron Advisors does not get any sort of commission or payment from SeekingAlpha if you sign up; we just think that publishing through their channel is valuable to you.)

November 27, 2006

Wall St. Journal of Today: Big Investors Turn to Network of Informants

Nitron Advisors is featured on the front page of today’s Wall Street Journal:

Big Investors Turn to Network of Informants

“For professional investors, something akin to what has done for the nation’s singles…hooking up middle managers from hundreds of companies with professional investors desperate for an investing edge.”

More (requires subscription or two-week trial)

UPDATE: Michael Mayhew posted the article’s text in full, without the graphic which discusses revenue of Nitron and other players in the space.

November 22, 2006

Investable Hedge Fund Indices: Investable Indices or Hedge Fund of Funds?

Posted in General, Public Markets Investing, Securities Research
by David Teten @ 6:33 pm —

I took some notes on Sandra Manzke’s talk at this week’s World Hedge Funds Summit . I have enclosed slides from her Toronto presentation and a Eurekahedge presentation.

Biography of Sandra L. Manzke

Sandra Manzke, Chairman and Chief Executive Officer, founded Maxam Capital Management LLC in April 2005. Prior to that, Sandra was the founder and co-CEO of Tremont Capital Management. She was responsible for the oversight of Tremont’s operations and the development of Tremont’s business plan. She was also a member of the Investment Advisory Board. Sandra oversaw the creation and sale of Tremont’s life insurance products, which were the first to use hedge fund investments.
Prior to the formation of Tremont, Sandra was a principal at Rogers, Casey & Barksdale, Inc., a pension fund consulting firm, from 1976 to 1984. While there, she served as the senior consultant to a number of major corporate/ERISA clients. From 1974 to 1976, she worked as an independent consultant at Bernstein Macauley where she was responsible for reviewing the firm’s investment products. She was at Scudder Stevens & Clark from 1969 to 1974, where she established one of their internal measurement systems during her tenure as an Investment Manager. Sandra holds a Bachelor of Fine Arts degree from Pratt.


Managers close, but they never close permanently.
When they reopen, they reopen for existing investors.
Such prominent managers as Marc Druckenmiller, Marc Kingdon, Marshall Wace are not in any index, so the indices are always partial.
Managers are slow to report sometimes, particularly after a down month.
When Cerberus closed to new investors, some indices took it out entirely. But then they reopened to new investors, and they weren’t let back in.

Providers of Investable Hedge Fund Indices include:
EurekaHedge & MAXAM
HFR: index is index of all funds that have managed accounts with them.
Dow Jones
Greenwich Van
Royal Bank of Scotland
Deutsche Bank—retail focused
S&P is no longer offering investable hedge fund index

Today 300 hedge funds in Hong Kong, about 300 in Canada
Now launching a LatAm product.
They launched a JV : Eureka is a data company, MAXAM is asset management.

How index is constructed:
- Assets over $50m
- Allocate initially to 30 largest managers
- Flexibility to match country allocation, market cap, and strategy comprised in index
- Rebalance semi-annually
- If a manager closes ,the fund stays in the index

A lot of fund of funds do not outperform the index, so people will move to the index. It’s much cheaper to move to the index.
$250K minimum

Hedge Funds: Insights in Performance Measurement, Risk Analysis, and Portfolio Allocation

Posted in General, Public Markets Investing, Securities Research
by David Teten @ 6:24 pm —

I enjoyed the October 30 Hedge Fund Panel Discussion by the authors of, “Hedge Funds: Insights in Performance Measurement, Risk Analysis, and Portfolio Allocation“, sponsored by the Chicago GSB Alumni Club of Greater New York.

Heidi Christensen Goldstein did pre-introduction
Then Cyrus Claffey, President Chicago GSB Club of NY, made formal introduction

Moderator: David K.A. Mordecai
Risk Economics Limited, Inc.

Mark Shore

Former COO of VK Capital Inc.
Morgan Stanley, New York

Hilary Till

Co-Founder & Portfolio Manager
Premia Capital Management, LLC, Chicago (
Formerly Chief of Derivative Strategies at Putnam, and formerly at Harvard Management Company. BA Statistics UChicago. Fulbright Fellow LSE.
Advisory board of natural resources hedge fund/fund of funds
Now editing a book on commodity investing

Fabrice Rouah

Ph.D. Candidate
McGill University, Montreal Institute of Financial Mathematics
Studies CTAs/hedge funds in general

Jacqueline Meziani

Senior Director
Standard & Poors, New York – hedge fund indices.
Chemical Bank, Citigroup
MBA Stern
10 years at S&P
Product Manager: Ops, marketing, licensing, research. My job is to catch things if they fall.

Mark Shore
Book excerpt and
Ch. 25
Study: modern portfolio theory assumes returns to be normal—but is this true? Most asset classes are not bell-shaped normal curves.
Can higher statistical moments (skewness, kurtosis) offer a clearer picture of risk-adjusted returns?
How do hedge funds and managed futures perform individually and simultaneously as diversifiers in a traditional portfolio?—expanded Harry Kat 2002 study of hedge funds and managed futures
Sharpe ratio is widely misused — Sharpe Ratio = (returns-RF rate)/std deviation

- historic results have some predictive ability
- mean and variance are sufficient statistics for evaluating a portfolio
- Distribution is symmetrical….BUT many studies have shown that time-series distributions are asymmetrical
- An investment with lower correlations (such as alternative investments) may add greater value with a lower Sharpe ratio

Sortino Ratio —– (return-MAR)/downside deviation —- is a better concept of downside risk.
If Standard Deviation goes up, does that mean risk has increased? Not necessarily.

Schneeweis & Spurgin (2002): the independent returns of alternative investments are not as important as how they may benefit the overall portfolio. Consider co-skewness of each portfolio component.

Co-skewness may be utilized to reduce “volatility shocks’ or tail risks
Kurtosis- the fatness of the tail by the peakedness or flatness of the returns distribution

Beckmann and Scholz (2003)
Kraus and Litzenberger (1976) support a rational investor’s preference for positive skewness and reducing volatility

Till (2002): mean-variance metric is most appropriate when returns are symmetrical. Thus using it for asymmetrical returns assumes the investor is indifferent between upside volatility and downside volatility

Kahneman and Tversky

Kat study (basis of Mark Shore work): asked if hedge funds and managed futures complement each other? Answer: yes, when managed futures receive >45% of alternative investment allocation.

Indices for Kat study: S&P 500 index, 10 yr Salomon Bros govt bond index, and a portfolio of 20 funds, and the Stark 300 index of managed futures
Shore study: S&P 500 index, Citigroup Corporate bond index, HFR fund of fund index, and CISDM

Conclusion: Sharpe ratio may overestimate the risk-adjusted returns by de-emphasizing the downside volatility of investments with negative skewness. Sharpe ratio may understate the risk-adjusted returns of investments with positive skewness by penalizing positive volatility.
S-ratio is a good ratio to use.

Ms. Hilary Till

Hedge Funds: Quantitative Insights
1. Return Sources
A. Inefficiencies

What is capacity of hedge fund industry (with an alpha advantage) ?
(based on argument in Foss (2004))

If hedge funds are exploiting inefficiencies, someone must provide them.

Maximum tolerance of average investor supplying inefficiencies: -50 basis points (assumption based on size of inefficiency in global fixed income markets)
Size of global capital markets: $55 trillion
Required excess return for hedge funds: 10%.
Ergo: implies the hedge fund industry could go to $2.75 trillion under management.
Caveat 1: prop traders also are fighting with hedge funds to exploit these inefficiencies
Caveat 2: many strategies are based on earning risk premia, not on exploiting inefficiencies.:
Relative-value bond funds, equity risk arb, value vs. growth, small cap stocks, high-yield currency investing. Examples drawn from Cochrane 1999ab, etc.)

I. Return Sources
C. Illiquidity

Reason: tick-by-tick evaluation of a good investment is painful.

Nassim Taieb (2001), Fooled by Randomness, Table 3.1:
An investment of 15% return, with 10% volatility/year, implies:

Scale Probability of Making Money at Different Scales
1 yr 93%
1 q 77%
1 mo 67%
1 day 54%
1 hr 51.3%
1 min 50.17%
1 sec 50.02%

So on a tick-by-tick scale, you’ll suffer about half of all days from a feeling of losing money

Fabrice Rouah
Review of the Academic Hedge Fund Literature (Ch. 13)

1. Performance Persistence—do winners repeat?

3 methods to analyze this:
+ 2×2 contingency tables
+ binomial model (multi-period)
+ regression of current performance returns on past rerturns

Summary: Little evidence of persistence, especially long-term
Most persistence is due to losers continuing to lose
Some losers increase volatility in attempt to boost returns.

2. Factor modeling

No transparency, so investors attempt to identify factor exposures. Important for anyone holding several funds (pensions, FoFs)
Helps to eliminate funds with similar strategies.
Linear models are difficult because of the non-linear relationship between HF returns and asset returns (options, short-selling).
R squareds for hedge funds are dramatically lower than those for mutual funds (which are typically 0.8-0.9), i.e., these conventional factors have low explanatory power.
Particularly important study: Agarwal & Naik 2004
Non-linear returns make linear modeling difficult

3. Portfolio diversification

Many styles have low correlation with equity & bond indices. Stress testing indicates they hold up well during market downturns.
Funds should not be co-integrated with markets or with themselves
Adding hedge funds to a traditional portfolio increases its risk-return profile
Simulation indicates 5-20% allocation

Correlations: tend to be low (0.37 vs. S&P 500). High p value means there’s not enough evidence to show that correlation is anything other than zero.

4. Survivorship bias

Compares returns of portfolios. This is the bias you will experience if you analyze a portfolio that contains only live funds. Usually about 300 bps.
In Mutual Funds, it’s usually <100 bps.

This is the most important of all biases.

5. Survival analysis

how long can HFs be expected to survive, and how fast do they die?
New area of research
New inflows are from institutional investors
They wish to invest long-term, but are worried about high attrition rates. Seek funds with longevity
Factors driving survival are the same factors driving survivorship bias.
50% survival time (i.e., half-life)= one-half funds die before this date, and one-half die after. Estimates are of 5-6 years. Most of these studies are very biased because they usually only use funds born after 94. But one of the better studies says >10 years.

No surprise: low returns, small asset base, young manager age all correlate with high mortality

Jacqueline Meziani

Disclosure: “I am not a quant.”
Edward Blum, my former colleague, is the major researcher on this chapter
Studied equity long/shorts

Short position serves following purposes: alpha generation, hedging of market risk, earning interest on short position while collecting short rebate
Managers may use futures and options to hedge their positions.

Overall, net exposure of E L/S funds tend to have a positive bias.

High beta funds usually have high net market exposure are often concentrated. Moderate beta funds hold proportionately more short positions that would lower net market exposure.

High beta variability may indicate several things: manager consistently includes securities different from those in benchmark. A market-timing fund manager is controlling beta. A stock-picking fund manager does not manage beta b/c he is concerned primarily with fundamentals of stocks in the portfolio

Investable E L/S indices are fairly clustered

Managers tend to go long small cap stocks and go short large cap stocks. Managers want more liquidity on short side.

Negative relationships with value premium. These managers were taking long positions with growth stocks and short positions with value stocks (although this finding is less robust).

On average, E L/S hedge funds returns are drivne by returns of the global equity market, size premium, and the value premium.

November 20, 2006

Quantitative Hedge Fund Strategies

Posted in General, Public Markets Investing, Securities Research
by David Teten @ 12:04 am —

Jason Prole, Quantitative Strategist at Capital Risk Management Inc., presented an interesting talk on “Quantitative Strategies” at the World Hedge Fund Summit in Toronto. slides here.

November 12, 2006

Ian Bremmer- Hedging Political Instability for Insight and Profit

My colleague Scott Lichtman took notes on Ian Bremmer’s talk Monday night at this past week’s World Hedge Funds Summit . Dr. Bremmer’s prediction that Rumsfeld would resign proved accurate within 48 hours.

Ian Bremmer, President of Eurasia Group, and author of The J-Curve: A New Way to Understand Why Nations Rise and Fall, spoke about understanding the stability of political regimes and how investors can pick the right countries/regions, sectors, and investment strategies to make the most of this analysis.

Opening question: Why is Iran a much greater risk to the world economy than North Korea? What does China take from the US during business negotiations that Russia doesn’t?

These questions are addressed through his theory of the “J-Curve”. Imagine a graph with Societal Openness on the Y axis and National Stability on the x axis. The graph line starts high on the left as very closed nations are very stable, plunges downward moving right as nations that attempt small become much less stable quickly, then gradually rises towards greater stability as open policies such as rule of law, freedom of press and democratic voting proceed. Think of the Nike swoosh with the tail opening on the right – or a check mark with a rounded bottom.

Iraq, on the upper left, was stable under Hussein’s closed (oppressive) regime policies, in terms of impact on the economic markets. The direction of shifts in the J-curve has implications for the size, type and duration of investments in a given country. Some of this is common sense, but Bremmer’s knowledge of the political environment, layered on the J-curve analysis, makes for very worthwhile food for thought.

See more below on China (and role in Africa), India, North Korea/Japan, Russia and oil, and the US elections.

North Korea: The j-curve tells us that regimes like this naturally rebound to maximum ‘closed’ status. Open democracy is far too risky for the regime to ever consider, so trying to isolate the country through sanctions actually is a reward for Kim Jong-Il. They’re calculating their position – alerting the world ahead of a nuclear test, so that the US and China could coordinate positions, with China’s interest in maintaining status quo to gradually ascend as regional superpower, damping any real sanctions.

The worst case for Korea is if Japan and China agree and N. Korea can’t play them off each other. Japan may become the ‘Israel of Asia’ – close US ties, longstanding differences with its neighbors, nuclear capable . If Japanese and Chinese economies slow and their governments want to bolster popular support through rhetoric, watch out for potential sea-based military conflict. But it’s most likely that those economics grow and N. Korea is relatively harmless - all the government really wants is money and self-preservation. (and cigars and brandy)

In China, the pro-growth politicans are out. That’s not a problem, because for 5 years there has been gridlock on any issue like IP protection or foreign investment in assets. With a more conservative government in place, they can actually afford to make a few accommodations in these areas that will keep relations stable with the US.

Bremmer predicts a worsening situation in ’08, at the time of the Olympics in Beijing. “Scheduling it in 08 was a mistake.” That’s in the middle of a US election, when congressman will use the high profile event to put pressure on trade and human rights issues. While the Chinese will do their best to focus on a smooth Olympic event with an agenda on Tibet, free press, the Shanghai faction will attempt to make noise or worse. There’s a 20-40% probability of a modest shock occurrence during the event. Compare the Atlanta Olympics.

China is taking maximalist investment positions in unstable countries. Chinese is being taught as second language in African schools. 2 months ago in Zambia elections, a candidate promised he would recognize Taiwan as a nation. That even being an issue shows a lot of anger about China investing in copper, being close to dictatorial local governments, smashing trade unions, etc. China is starting to control commodities sources.

One offsetting factor for the decline in US influence is Bill Gates and the Gates Foundation, which has more influence in certain failed countries than the US and many European nations. “Bufffett’s donation to the Gates Foundation was some of the best foreign policy news I’ve heard.”

India: A great environment for the top 2% of the population, which makes a case for investing in luxury products. But will they gain a solid middle class? Bremmer thinks most pundits are too optimistic and we’ll see slower than expected growth in metrics like purchase of cars.

Russia: Relations with the US are in their worse state since Kosovo. The government is going after the metals, telecom, auto, aviation industries – anything they perceive as strategic. If you are working or investing in a strategic sector and not aligned with Putin, you are in trouble.

Russia has a rising middle class, even in Siberia. If you’re part of this market – consumer brands, high-end services, corporate office building – then you’re making money.

Russia feels humiliated about zero sum game with West in last 10 years. Under Clinton, we created an oil pipeline from the Caspian Sea to Europe bypassing Russia. Russia lost control over Georgia and the Ukraine, now they’ve gotten the Ukraine back and are trying to get Georgia back. If that happens, the trans-border oil pipeline contract will be renegotiated.

The good part about investing in Russia is they just want to rip you off monetarily. In contrast, in China they want to take your intellectual property, then compete with you.
Russia sees Iran as a useful geopolitical hedge against US in the region. China sees it as a problem to be contained.

Eastern Europe: looks good/stable. Romania/Bulgaria are relatively closed and hard to invest in, but their P/Es are cheap compared to other Eastern European countries.

Iran – He predicted some sanctions will pass unanimously. The markets won’t react immediately. Somewhere in 2007 it will get ugly. Iran has open press, young activists, which puts it on the volatile part of the j-curve. It benefits them to focus their population on the nuclear confrontation with West. Sanctions help them. But military action by Israel wouldn’t help him (stability-wise).

We have 18 months until the point of no return, when Iran can make nuclear weapons on their own, then 3 years until weapons are readily transportable, according to intelligence in US & Israel. Similar in Britain.

If moderates gain ground, then maybe political actions from the West will make a difference. But oil prices are too strong, which makes the closed society more stable. Israel will likely choose to attack Iran if it comes down to a close-range nuclear threat.

US elections: Bremmer predicted the elections’ impact, noting “Elections are tomorrow, so I get the chance to be wrong immediately.” He predicted Rumsfeld and/or Cheney stepping down, Cheney ostensibly for health reasons. This would allow the GOP to insert a fresh VP that could gain national prominence and become a momentum leader for the presidential race in ’08, saving the GOP from a wide-open (unstable) race. McCain is a front runner but is having good and bad days now (even for a President, he’s relatively old at 72). It’s very likely that neo-isolationism will pick up on many fronts – you’ll see it in trade protectionism, reactions to offshoring job losses, and immigration restrictions.

November 1, 2006

Seeking Ecommerce Experts for NY, Boston, Chicago, SF Hedge Fund Dinners

I thought that some of our readers might be interested and qualified to attend one of our upcoming private hedge fund dinners.


Seeking Ecommerce Experts for New York, Boston, Chicago, and San Francisco Hedge Fund Dinners
December 2006 / January 2007


Nitron Advisors is organizing a series of dinners for Ecommerce experts to talk with major hedge fund investors interested in this sector. These invitation-only events will be taking place in New York on December 11th, Boston on December 12th, San Francisco on January 16, and Chicago on January 17. We will compensate you for flight expenses, and give you a stipend for joining us.

We’re looking for senior industry executives and other experts with the following backgrounds:
+ online specialty retail (eBay, Amazon, Blue Nile, Overstock, Audible, etc.)
+ online auctions (power sellers on eBay, other auction sites)
+ search engine space (Google, Yahoo, MSN)
+ consumer generated media/ free video hosting services (YouTube, MSN Video, Yahoo Video, Google Video)
+ online advertising/marketing (ValueClick, 24/7 Real Media, aQuantive)
+ lead generation players (Autobytel Inc, Move Inc, Bankrate, IAC InterActiveCorp, HouseValues, etc.)
+ Online media (PRIMEDIA, New York Times/, etc.)

Qualifications: As an expert, you have at least four years senior experience in the eCommerce space. You have a “big picture” perspective on different firms in the space.

If you are not already a member of our Circle of Experts, please visit and apply to be a member of the Nitron Advisors Circle of Experts. Please contact Mr. Jesse Mandell, 1-212-682-6455, JMandell(AT), with any questions. Please note that we must review your bio and talk with you before we can accept you for the dinner.


I should also mention that we’re hosting a dinner on Nov. 15 for consumer technology experts in New York. We’re interested in experts in PCs, flash memory, MP3 players, GPS systems, and mobile telephony. Register at Contact Mr. Jesse Mandell, 1-212-682-6455, JMandell(AT) , for details. We’ll reimburse flight expenses.

October 18, 2006

Mohamed A. El-Erian, President & CEO of Harvard endowment, on the global economy

I went to a very worthwhile talk last night at the Harvard
Club by Mohamed A. El-Erian, President and CEO, Harvard Management Company, which manages the $29 billion Harvard endowment (as of 6/30/06). The endowment has had consistently impressive performance. As background, I’ve posted on the blog below an article I wrote for the Harbus, the HBS school newspaper, back in 1998, profiling Jack Meyer (Dr. El-Erian’s predecessor).


One of the marks of a sophisticated thinker is that he can make complex subjects seem simple. The global economy is certainly complex (especially now) but this talk boils it down to just a few key issues and tensions.


My notes:



"Navigating a Fluid World"

Presentation to the Harvard Club of New York

Mohamed A. El-Erian, President and CEO, Harvard Management Company

and Faculty Member at Harvard Business School

Oct. 17, 2006




You’re obviously not Mets fans or else you wouldn’t be here.


Will discuss impact of global economy on investing. Internally,
we’ve gone back to 1st principles as we rebuild HMC.


Signals from the market are increasingly inconsistent (i.e.,
confusing). We’ve come across issues that are systemic in nature, uncertain in
impact. And we have lots of questions. Some will think we don’t know the
answers. Some will think we know but aren’t telling. And you’re both right.


Market signals which used to appear sequentially
inconsistent now appear simultaneously so. So very tempting to dismiss them as
noise. Don’t dismiss them as noise—they’re consequential in terms of info




1. What are the markets trying to tell us?


Signals have gone from being sequentially inconsistent to
being simultaneously inconsistent. 3 examples:


A) In the world’s most liquid markets, are US equities or
US bonds correct?
Equity market is doing well. Suggests vibrant economy.
But bond market suggests economy is slowing down very quickly. Last week, both
shape & level of interest rates suggest something more sinister than a soft


B) What to make of the unusual dispersion in interest
rate forecasts in the context of subdued volatility?
Some suggest by Dec.
07, Fed will cut rates to 4%. Some suggest Fed will raise rates to 6%. I’ve
never seen such a range in terns of magnitude and sign. Reason: we’re at an
inflection point in the economy.

Market volatility has declined (VIX index). Intra-market
differentiation in developed markets has also declined (graph: FTSE All-europe
valuation dispersion). EM Credit spreads have tightened in a quasi-linear
fashion (graph: EM Sovereign spread over USTs). FX market volatility has
collapsed (graph: avg. GX implied volatility).


C) Michael Cullen, New Zealand finance minister, says
investors in NZ are "irrational".
"Just how badly do we
have to do on the current account before investors notice? … I have to think
someone would have to be slightly strange to take a bet on the NZ dollar right


I can explain each of these inconsistencies, but not in a
self-consistent way. Harvard prof told me about this: "This is complex. But
in academe, we can just go to something less complex."



2. What are the underlying drivers?


3.5 major structural changes ongoing:


1) Global productivity shock. Secular, long-term in

Communications costs plummeting. Internet users spiking.
Less and less capital controls. Transport costs down. More and more regional
trade agreements. Greater involvement of new segments of the labor market.



2) Global terms of trade shock. Secular, long-term in

Significant increase in demand (from China, India, etc.) which won’t go away.



3) A financial innovation shock. Secular, long-term in

Proliferation of derivative-based instruments that lower
entry/exit barriers and facilitate many permutations of risk securitization,
tranching, and bundling.


3.5) New marginal price setters. Possibly short-term.

New set of marginal price setters have emerged: central
banks, hedge funds, private equity, etc. (Graph: Notional amounts outstanding
of credit default swaps have swelled enormously) This is ‘half a change’
because it’s not as yet clear whether it is cyclical or secular



Seemingly different objective functions, time horizons, and
guidelines now have an important marginal influence. I’m particularly talking
about central banks in emerging countries who have huge influence—China has $1trillian in reserves.


Compare playing the game of Risk. It’s a purely
probability-driven game. You’ll win if you can calculate probabilities. When
someone joins the game and behaves irrationally, all the others have to adjust
accordingly. In the financial markets, these are the non-commercial players
who have entered the marketplace.




A. Convergence in real economy indicators. Standard
deviation of global growth rate has converged to US growth rates. Global
interest rates have also converged to US. US is the global locomotive of
growth. It’s the Goldilocks economy.


B. Portfolio diversification and reduction in home biases.
Both assets & liabilities are becoming globalized. Countries own more
and more of one another; so does the corporate sector in each country. Over 50%
of US treasuries are held outside the US. This is a good thing—it’s
international risk sharing.


C. Unprecedented global payment imbalances.

US current account balance is at -$800B. Largest deficit
any country has ever run in terms of global GDP. In 1995, many countries ran a
deficit. Now, the US runs a huge deficit and relatively few other countries
do. We’ve never seen this imbalance. (Shows powerful slide from IMF.)


This is our "vendor-financing relationship" with Asia, aka "Bretton Woods 2". Asia supplies goods (and India supplies services),
and Asia also supplies credit for us to buy it. It’s like Ford financing your
car. It makes great sense for the US consumer, using his house as an
ATM—consuming above his income.


Why is Asia doing this? They don’t think about bits of
paper. They think about the benefits of being massive export machine: creates
jobs, which attracts foreign investors. Easier to import FDI (foreign direct
investment). Lastly, once you acquire market share, it’s hard to lose it.


This all turbo-charges int’l reserve growth among oil
exporters. They’re accumulating even more reserves than Asia.



3. What are the implications?

This is a "stable disequilibrium" (quoting PIMCO)


No agreement on lifespan of this. How long will Asia take bits of paper for their goods—when the bits of paper will lose value?




A. Optimists ("new paradigm school") looks
at: US productivity gains, demographics, entrepreneurship. Maturation of key
emerging economies. Gradual resurgence of Japan/Europe.


B. Cynics. Others believe we’re on verge of large
disruption: size of huge current account deficit, leverage in financial sector,
bubble in housing market, risk of a change in the asset preferences of holders
of US financial assets.



C. All the views in the ‘muddled middle’: those
noting ‘dark matter’ (measurement error), enhanced policy credibility, system


This is a frightening slide. Endowments and foundations have
to focus on long term, and there are question marks about what the long term is.



Future is function of four factors:


Developments in the US in private consumption. Will consumption
soft- or hard-land?

Developments in surplus countries, including relative asset
preferences and ‘managing success’ (suddenly being in surplus). Finance
minister told him: "Managing success is more difficult than managing a

Interactions between the two. They’re two sides of an income

Prospects for orderly re-alignment of exogenous and endogenous


The challenges for policy reaction functions in advanced

- navigate payment imbalances

- understand and adjust to structural changes

- counter protectionist tendencies


The challenges for emerging economies:

They’re used to running a deficit—that’s what the
textbooks suggest. How do they handle this?


Theoretical orderly global solution exists, and is
discussed at every G7

+ Rebalance of US economy—US must consume less.

+ Structural reform in Euroland and Japan to grow faster.

+ Asia has to consume more.

+ Oil exporters provide cheap financing in the interim.


BUT: if any one of these parties moves first, they’re hurt.
This is a classic game theory dilemma/prisoner’s dilemma. So without
coordination, it’s best not to move.


G7 can’t act as a coordinating body because it excludes the
countries in massive surplus. So we rely on IMF and other multilateral


At a time when int’l coordination is essential, legitimacy
of multilateral institutions is being questioned due to: lack of representation,
governance, resources etc.


Business models have to adopt: new two-way flows between
advanced & emerging economies. Regional and local product development.


Just 5 years ago we thought emerging economies were a
destination for capital; now they’re the major source of capital.


Most companies have outperformed lately because growth
outside US has been stronger than envisioned.


Investment management is about 3 things: asset allocation,
investment vehicles, and risk management. Not very complex.


Key questions for investors:

striking the right balance between forces of economic synchronization
and de-coupling.

Portfolio positioning in the context of binary medium-term outcomes

Appropriately handle the internationalization of investment management

Dealing with asset class fluidity and correlation changes

Ensuring value for money in accessing investment vehicles


Navigating organizational challenges.


Buying real estate in Mexico is very different than buying
bonds there.


Traditional classifications no longer make sense.


How to ensure value? Fees get very high when everyone wants
a certain asset.


Risk management is going to be increasingly important.
We’re rebuilding and reinventing the institution of HMC.




These signals are meaningful. Global economic convergence
has continued while fluidity of int’l monetary system is increasing.

At public sector level, we need to test and retest
robustness of nat’l policy reaction functions and global governance.





Q: As you know there are 8,000 hedge funds. Is this a


Hedge funds are not asset classes; they are a means of
managing investments. They do 2 things different from tradition: a) they
leverage, b) they can go short and long. Like everything else, if taken to
extreme, these actions can cause problems.


3 distinctions:

- Are they a threat to stability? Amaranth at least was not,
despite losing more money than LTCM.

- Are they a threat to the small uninformed investor? Those
investors shouldn’t be in them.

- Do they potentially contaminate economic relationships?
Are they a level playing field?


Q: Insights on Africa, Egypt? On carry trades?


Most crowded carry trades in April were in NZ, Turkey—all funded by yen. You could borrow at 1%, get 10-17% returns in NZ, Turkey. Then certain markets dropped by 20-30%—and nothing blew up. Carry trades have
tendency to become more crowded.


Q: How do you handle risk management?


1)      Buy
cheap insurance on fat tails

2)      Analyze
correlation of exposures across and within asset classes.


Q: What is optimal compensation scheme for outside funds
and for your own employees?


Several new hedge funds have overly generous comp schemes,
and we tend to avoid them.


For our own employees, we have clawback provision. If they
don’t consistently outrperform, the carry they earn is clawed back.


Q: Aren’t US markets much more sophisticated? US markets
providing a service to global economy.


There’s a view that Asians don’t trust their own markets.
So they delegate capital allocation to the West. I think that’s an outcome,
and not a bad outcome, but it wasn’t by design.


Part of the orderly solution is for emerging markets to
develop more sophisticated capital markets.


At some point Asian populations will ask for bridges,
schools, etc.


Q: Opinion on china?


HMC has increased the emerging markets allocation by $1b+.

One of the reasons managing success is tough is that the
typical emerging market is not used to deal with large capital inflow.

How do you get out of overinvestment? Because China is mostly a closed economy, you can work off overinvestment over years, unlike the typical
boom/bust of Thailand, Argentina, etc.


Q: Hedge funds account for ½ of NYSE volume. Doesn’t
that call for regulation?


Have not thought about this.


Q: Where are you investing?


We think US fixed income market is near a secular top.

We think US economy will soft-land, either for endogenous
reasons (housing market corrects but corporate investment picks up) or will soft-land
because of enormous monetary market flexibility (Fed could cut rates). It’s
hard to imagine foreign markets doing better than US when US goes into
recession. So there’s no safe refuge.


If world goes into recession, you want a liquid market. We
think of recession as a risk under our ‘fat-tail’ insurance.