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Back of the Book Value
March 27th, 2009
I thought the chart below may be of interest. We compared performance results of Stanford’s investors taken from the SEC complaint1 with one of the largest stable value funds (name withheld). Stanford results in the complaint go only through 2006 and that’s why the line stops there while the stable value fund continues its upward trend through 2008.
- Please see my previous blog post [↩]
Stable Value a free lunch?
March 5th, 2009
Recent cases of alleged fraud involved investors placing billions of dollars in unregistered products attracted by smooth positive returns. Hedge funds and other unregistered investment vehicles do not have a monopoly on “stable” positive returns. In fact, there exists a class of products known as stable value funds that share similar stable return characteristics and can be found in many retirement plans. Read more…
SEC vs. Stanford: same return for two years – a red flag?
February 21st, 2009
On February 17th, 2009 the SEC charged Stanford International Bank (SIB), R. Allen Stanford, et al with “a massive ongoing fraud.” Below are comments regarding potential challenges to SEC’s rationale and approach in supporting their case presented in the complaint on SEC website.
As shown in the excerpt below, the SEC points to SIB’s absolute performance vs. market indexes:
“Double-digit returns… over the past 15 years” which refers to the chart in Par. 28 of the complaint. Note that these are gross returns, while net returns paid to investors were about 8%. Many hedge funds generated higher after fees returns in 1992-2006. Plus, Stanford returns were high three and five years ago, so there must be something else.
Very suspicious performance in 2008: the fund lost “only” 1.3%. Guess what? So did a quarter of all hedge funds. According to the latest HFR data, 1318 hedge funds out of 5313 reporting lost less than Stanford in 2008. And so did about 12% of mutual funds (excluding money market).
Par. 4 of the complaint states that for SIB producing the same returns of 15.71% for two consecutive years 1995 and 1996 was “impossible” to achieve if Stanford have managed a “global diversified” portfolio of investments. Here’s the exact quote from the complaint:
So when did identical returns for two consecutive years become a red flag? This seems more a sign of transparent reporting. If someone were to concoct a fraud, the first thing they would do is to change at least one decimal to make it less suspicious! And by the way, what should be considered a red flag–is 1bp difference sufficient? How about 5bp difference?
First we should note that it is statistically “probable” and “possible” to obtain the same investment return for two consecutive years even when one is invested in liquid market instruments. Highly diversified portfolios would increase the probability. Diversification reduces volatility overall and aggregating volatile data into annual returns further reduces volatility. In addition, if underlying assets have similar performance during these years it increases the likelihood of the portfolio achieving similar results.
We ran a quick test and found about two dozen mutual funds and hedge funds having 1995 and 1996 returns within 10bp range. Note that these are only survivors and the number of actual funds that existed at that time could be easily 2-3 times higher. There are some identical matches in consecutive year performance and for many funds 1995-96 results are within 2-3 bp range.
So is it really a red flag? Well, not by itself based on the above considerations. Whether these numbers represent real returns and are not made up requires more sophisticated analysis such as returns-based (RBSA) and other quantitative due diligence methods.
Fairholme Fund
January 19th, 2009
In the January 3rd 2009 article “Mutual Fund Fought Off Bears but Now Is Clawed” The Wall Street Journal reporter Eleanor Laise attempts to find an explanation of the Fairholme fund’s subpar performance in the last quarter of 2008. She interviews fund manager Bruce Berkowitz as well as industry experts, analyses fund holdings, and looks at the most recent stock picks. Her conclusion: the fund made all the right sector moves (e.g., got rid of energy and financials) and its otherwise exceptional performance in 2008 has been marred by just a series of poor stock bets. The article concludes with assurances from the fund manager that the strategy is sound and that all the bets will pay off. We also learn that Mr. Berkowitz now has almost 100% of his net worth invested with his fund. The latter is indeed a good sign but we believe that a sophisticated investor deserves better insight on what the future might hold for this outstanding fund.
By performing an analysis of the Fairholme return record using MPI Stylus we tried to connect the dots to understand the sources of the fund’s past performance and provide some guidance in what to expect in the nearest future.
“Ignore the Crowd”
Fairholme fund indeed has an exceptional track record. It outperformed the S&P 500 index every single year since its launch at the end of 1999 except for 2003. Even last year, which was the focus of the WSJ article, the fund outperformed the index by 7.3%.
Fairholme is a no-load mutual fund with an expense ratio of 1%. Its manager is true to its motto “Ignore the Crowd” as prominently featured on the fund’s website. The fund makes focused sector and securities bets. It’s concentrated, holding about 22 stocks. The top ten holdings account for 64% of its assets (according to August 31, 2008 data.) We consider this degree of concentration to be especially high given the fund’s size of $7.2B. Annual turnover is only 14%.
Fairholme is classified as Large Blend by Morningstar and Mid-Cap Growth by Lipper. This seems a little odd, though it’s not surprising for fund research firms to disagree on such a concentrated portfolio. We performed a returns-based style analysis of the fund to better understand its style exposure. Then we undertook a second analysis with its focus on sector exposure to get at its underlying strategy and to determine the sources of its past and recent successes. This put us in a position to either confirm or refute conclusions presented in the reporter’s story.
In the chart below we show the fund’s cumulative performance since inception vs. the S&P 500 Index. A chart similar to this is prominently positioned in Fairholme’s semi-annual 2008 and annual 2007 reports. Note the accentuated 2008 loss—that’s how performance appeared to long-term Fariholme investors.
The depiction of the drop in 2008 seems a bit confusing given that Fairholme outperformed the index by 7.3% that year. For this very reason we find such “growth” charts to be very misleading because the compounding of a single-period return outlier gets multiplied and creates a distorted view of a fund’s performance. A simple cure for this problem is to employ a logarithmic scale on the y-axis as in the chart below. Doing so shows that most of the gains are attributed to years 2000-2002 while over the past several years the fund’s performance was more or less in sync with the S&P 500 index.
Fairholme could help itself either by replacing their growth chart in the 2008 annual report with this alternative form or by showing the fund’s annualized performance next to it. Such a chart will give the fund deserved credit for its outstanding track record despite recent losses.
Getting Under the Hood
In order to determine the drivers of the fund’s performance we needed to perform a returns-based style analysis (RBSA) of the fund. As a reminder, RBSA attempts to create a dynamic portfolio of generic asset indices that replicates the analyzed fund’s performance. For our analysis we use the nine years of Fairholme monthly returns1 through the end of 2008, the six Russell style indices, and the MSCI Canada equity index to represent Fairholme’s significant exposure to Canadian stocks. The results of the analysis are presented in chart below.2 Note that we didn’t use any holdings information to produce these results. All we needed was a stream of monthly return figures.
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