ETF Prime Archive

How Did Madoff Happen?

A lot of people are wondering how, in this age of Sarbanes Oxley, someone catering to sophisticated investors could pull off a $50 billion Ponzi scheme.  Didn’t the internet bubble, Enron and WorldCom teach investors and regulators anything?

The answer is complex, and has a lot to do with the lack of transparency and regulation in the hedge fund world (both to change soon).  More broadly, it has a lot to do with human psychology.  This isn’t the first major financial scandal to come undone during a financial crisis and it certainly won’t be the last. This is conveyed perfectly in this passage from John Galbraith’s book “The Great Crash of 1929” – – I found the quote at Andy McSmith’s blog.

“To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man, who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s businesses and banks. This inventory – it should perhaps be called the Bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.

Just as the boom accelerated the rate of [embezzlement] growth, so the crash enormously advanced the rate of [embezzlement] discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. Audits were ordered. Strained or preoccupied behavior was noticed. Most important, the collapse in stock values made irredeemable the position of the employee who had embezzled to play the market. He now confessed.”

ETFs Still Talking Market Share

While we still have unpredictable swings in the market each day, and the implications of the government’s rescue package are uncertain, there is one trend that has become reliable – – the continued growth of ETF market share gains against mutual funds.  The latest industry statistics are out from the Investment Company Institute, and as the graph below shows, the share of all ETFs as a percentage of non-money market mutual fund assets is up to 7.4%:

Perhaps even more ominous for the mutual fund industry is that net redemptions from mutual funds accelerated while there was actually net growth in ETF originations.

A Good Holiday Read: Crash Proof

Anyone looking for a well-written, concise description of the economic underpinnings of the financial crisis would should spend some time over the holidays reading Peter Shiff’s “Crash Proof: How to Profit from the Coming Economic Collapse” [link to Amazon].  Shiff’s book was published not very long ago – in 2007 – but before this year he had often jokingly been referred to as ‘Dr. Doom’ or Chicken Little.  Nobody is joking anymore.

In a straightforward writing style that any non-finance person can understand, Shiff walks through how the policies of the Federal Reserve, trade deficit, lack of savings, and other factors lead to an economic bubble that started to unravel this year.

Shiff warns of very tough times ahead, with a decline in the dollar and stagflation contributing to a painful period of sacrifice as our economy is rebuilt.  He gives his views on the best ways to invest during this period – foreign currency, developed international markets and commodities; all of which are intended to profit from what he believes will be a long-term decline in the US dollar.

Shiff’s writing style isn’t for everyone – he is blunt and pretty cynical.  He also doesn’t give you a warm fuzzy about our economic future and he pimps his own firm a little too much.  But if you want to understand some the macroeconomic reasons the markets have tanked this year so you can protect yourself and improve your odds at success in the future, it’s required reading.

A Cruel Joke – Mutual Fund Fees Going Up!?

As if 2008 wasn’t bad enough, now comes word from Investment News that mutual fund expense ratios might actually be going UP next year.

According to the article, as mutual fund assets have gone down due to both market declines and redemptions, there are fewer revenues to help cover fixed costs, such as accounting and legal fees, call centers, insurance premiums, real estate costs, as well as fewer shareholders left to shoulder those expenses.

I’m not sure the mutual fund companies won’t go ahead and accept lower profitability. The growth of ETFs and their lower cost structure will continue to put pressure on the industry to reduce expenses.  As the article quotes one investment advisor, “If a fund (expense ratio) goes up to 1.9% from 1.4%, after they lost more than that in the market, I’ll look at ETFs.”

Inside Commodities Conference

I had the opportunity to attend the Inside Commodities conference at the New York Stock Exchange last month.  The conference featured a Who’s Who of bigwigs from different corners of the commodities industry.  I wish anyone who doubts that commodities belong in everyone’s long-term portfolio could have been there.

The highlight of the conference was a keynote speech by Jim Rogers, of Investment Biker fame (check out Jim’s blog for yourself). Jim presents a compelling case for buying commodities.  Some highlights from his presentations:

• Economically, the 21st Century belongs to China (Jim is having his daughter learn Mandarin Chinese) similar to the way the 20th Century belonged to the United States.
• He doesn’t agree with the Federal Reserve’s handling of the financial crisis, claiming that the inflationary impact of their efforts to avoid deflation will have negative consequences for our economy for a very long time. He believes we will experience a gigantic shift away from paper assets into real ones.
• Jim claims that commodities are the second largest asset class in the world, but that most people don’t know how to use commodities to protect themselves. According to Jim, there are tens of thousands of mutual funds an investor can choose from, but fewer than 100 that invest in commodities. He’s sure people will learn about commodities soon, though, similar to the way most people who couldn’t spell the term ‘mutual fund’ forty years ago have embraced them since.
• Bull markets in commodities historically last 18-20 years, so he is guessing it will be time to get out of commodities around 2020. The current drop in commodities prices doesn’t count as a bear market to Jim. He says we are undergoing an asset liquidation that has only happened eight or nine times in the last 150 years – the current one resulting from massive hedge fund deleveraging
• Many commodities face an unrelenting increase in demand as developing countries industrialize while we face a depletion of our natural resources. For example, in emerging economies, people want more protein in their diet as their per capita income grows. A small increase across millions of people puts an enormous stress on the world’s ability to produce the grains, livestock, etc. needed to meet that demand.

Anyone interested in learning more about Jim should check out his blog.  I would also pick up his book “Hot Commodities”, which is a quick read and explains in depth his investment thesis for each class of commodities.