December 2006 NEWSLETTER

Welcome to the Desert of the Real—
Real Investment Returns in a Dry Season.
January 2006ãRobert C. Feightner

Welcome to the Desert of the Real.[1] This issue of the newsletter is the eighth in an ongoing series and the first of 2006. It is free of charge and directed to anyone who wants better investment results.

As of the writing of this Newsletter, the Author’s weblog, Desert of the Real Economic Analysis, has been running for a little over three months. Nearly all of the posts have dealt with investing or economics, although a handful venture from Ducati Sportbikes to hyperreality to the comical canard of the “war on Christmas”.[2]

The volume of the posts (there are over 100 to date) provides ample raw material for this newsletter. So for the time being, this Newsletter will contain the best of the posts from the prior month or so.

This Newsletter will follow up on Alpha, a difficult but critical topic for mutual find investors. Alpha was also the topic for last month’s newsletter. But since it is a tough topic, we will come at it again.

You should never purchase shares in a mutual fund without comparing its Alpha with comparable funds. And you should also compare the Alpha(s) of your current mutual funds relative to comparable funds. This is the time of year when many people look at their portfolios or rejigger their 401(k) investments.

We will finish up with some thoughts for nest year.

A POSTIVE ALPHA IS A FREE LUNCH. THE NEGATIVE ALPHA INVESTOR GOES HUNGRY

Alpha can be a difficult concept to understand. The last newsletter took on the topic and a post from last week rehashed Beta. Beta, as readers should recall, is the volatility of an investment when compared to the volatility of the S&P 500 Index.


Let’s start again with the definition of Alpha:

Alpha is a risk-adjusted return on an investment. Alpha demonstrates whether your investment outperformed or underperformed a risk-related benchmark. If you outperformed the benchmark, then you got more reward for a given amount of risk. If the investment underperformed the benchmark, then you took on extra risk to get less reward. Alpha is measured in percent of overperformance or underperformance. (i.e., Alpha of 1, 2, or -.5 or –1)

The basic question that Alpha asks and answers is: did you get more reward or less reward for a given amount of risk? Let’s look at the concept of a “given amount of risk”. To do so, we will spin the Roulette Wheel.

Roulette is a mainstay at most casinos.[i] The Roulette Wheel is a spinning wheel with 64 numbers[ii]. The wheel is spun and then a ball is released. There are slots in the wheel that correspond to the numbers. There are two sets of numbers 1 through 32, with a set in red and a set in green. Your odds of hitting Red 1 or Green 32 are one in 64. 1:64. If you bet on Red 1 and win, you get $35. So 1 unit of risk gets you $35. But there are other ways to play. Lots of bets, but let’s focus on just as couple.

You can bet on the wheel hitting a Red number or a Green Number. One-half the numbers are Red and one-half are Green. You have a much better chance of winning betting on Red or Green, but your winnings are correspondingly smaller. You have a 1 in 2 chance of guessing Red or Green on each spin of the wheel and the payout is $1, 1:2. For a lower risk bet, you get a lower reward.

When people invest in riskier stocks or bonds, they demand a higher return. They demand a higher return because their chance of earning the expected return is less than it is with a safer investment. This is a logical approach, but it often breaks down. It breaks down for two reasons. First, it is often difficult to determine if you are exposing your investment to more risk than necessary for the expected return. Accurate information and projections are not always available to perform the risk/reward assessment. Second, most investors do not even engage in a thorough risk/reward assessment.

ALPHA GIVES MUTUAL FUND INVESTORS THE TOOLS TO ASSESS RISK AND REWARD

Let’s go back to the Roulette wheel. Remember the bet on a single colored number. One dollar, or one unit of risk, will get us a $64 (Check) reward. And one unit of risk will get us one additional dollar if we make a 1:2 bet on Red or Green. The same kind of risk/reward analysis, using historical data, is what Alpha can tell us. Alpha cannot guarantee future risk/reward, but it does give us historical data that we can use in making projections.

Let’s revisit the Alpha calculation we did in the earlier post. For this calculation we will use the Slow and Steady Value Mutual Fund. Last year, the Slow and Steady fund returned 10%. And in doing this calculation we will bring in a couple of other financial concepts. You won’t need a calculator Just follow the Bouncing Ball . . .


Risk-free rate of return. One of the first things you need to know to calculate alpha is the risk free rate of return. This is not hard to calculate, however. The risk-free rate of return is the interest rate paid on a US treasury note. Why the Treasury Note? They are considered risk-free because they are guaranteed by the “Full Faith and Credit” of the US government. So let’s say that a 6-month Treasury note is paying 4%. So the risk-free rate of return is 4.

If we invested in any investment considered to be more risky than the US Treasury Note, like stocks, bonds, nearly anything else and earned less than 4%, we got less reward for taking more risk. But if we invested in nearly anything else and got more than 4%, we might have gotten more reward for less risk. But we won’t know until we do the Alpha calculation.

Let’s follow the analysis and work up the Alpha equation at each step. Slow and Steady returned 10% last year. The risk-free rate of return was 4%.

10 (Slow and Steady Return-4 (Risk free rate of return)) = 6. Slow and Steady exceeded the risk-free rate of return by 6%. Pretty good. But we still won’t know if Slow and Steady gave us a higher return or a lower return for the amount of risk we incurred until we complete the Alpha calculation.

Excess Return. In a good year for the stock market, many stocks and most indices will have a higher return than the risk-free rate of return, or the interest paid on a Treasury Note. Slow and Steady had an excess return of 6%. However, the excess return has to be considered in light of a benchmark for similar investments.

Slow and Steady is a value stock mutual fund. For a comparison with an index of comparable stocks, we will compare it with the Russell 1000 Value Index[iii]. This is an index of large capitalization value stocks. Last year this index returned 7%. So the benchmark excess return for large cap value stocks is:

7 (Large value stock benchmark)-4 (Risk free rate of return) = 3

Beta and Expected Excess Return. Remember Beta is a volatility measurement. We need this figure to compare our risks with our returns. The excess risk we would expect for a our large value fund is calculated as follows:

Beta * Excess Return for Benchmark = Expected risk-adjusted return

.8 (Beta for Slow and Steady) * 3 (Excess Return for large value index) = 2.4

So the expected excess return for Slow and Steady is 2.4%. This number is critical. This tells us the return we should have earned on a value stock mutual fund. If Slow and Steady mutual fund exceeded this 2.4% return, then the investor for more reward for less risk. But if our mutual fund lagged this 2.4%, then we got less reward for the risk we took by investing in a Slow and Steady.

Alpha. Whew. Finally. And as you have figured out by now, Slow and Steady placekicked the competition and earned us a lot of excess return for the risk we took.

6 (Slow and Steady’s Excess Return) – 2.4 (Expected Excess Return) = 3.6 Slow and Steady has an Alpha of 3.6%. This means you got a return of 3.6% above and beyond the return you should have expected given the risk that you took (as measured by Beta) for investing in Slow and Steady. You should send the Fund Manager a Christmas Card and a Chia pet.

HOW DO YOU FIND THE HIGH ALPHA FUNDS?

Morningstar is a common source of investment information. Many public libraries have Morningstar services. Your broker or investment planner may also have access to Morningstar services. Also, many mutual funds will post their Alphas and Betas on their websites. But remember, Alpha is only one measurement in the selection of a mutual fund. But it is an important one.

WHY ARE WE HERE? ARE WE ON EARTH JUST TO PAY BILLS AND THE MORTGAGE?

If you will wake up Christmas morning and look at a pile of presents that will take until April to pay off (just in time to charge your tax bill), or are already dreading that long commute tomorrow, then next weekend should be easier for you. You need to make only one New Year’s Resolution. Ask the question “why”? You won’t get the answer the next day or probably within the next week. But ask the question again and again, and whenever fifty bucks goes into your gas tank or you wait in the drive-through lane for 15 minutes for tasteless food you will eat in your car.

CHRISTMAS PRESENTS AND A NEW YEAR RESOLUTION

In the merchant world it is often said that “well bought is half-sold”. In the personal world, perhaps “well-asked is half-answered.” Give yourself the Christmas or Chanukah present you really need at the deepest level of your soul, your spirit, your consciousness. Ask “WHY”. The answer to the question “how to simplify your finances, simplify your life, simplify the life of your family, and find the next off ramp,” will come.

Welcome to the Desert of the Real!

IMPORANT DISCLAIMER: This newsletter is offered for informational purposes only. Sources of information provided are believed to be reliable, but are not guaranteed to be complete or without error. Opinions and suggestions are provided with the understanding that readers acting on information contained herein assume all risks involved. The Author may or may not buy or sell securities discussed in this newsletter.


About the Author: The Author is a former corporate healthcare attorney, computer software company executive and stockbroker for a major wire house. He currently lives in Albuquerque, New Mexico. He trades for a living, works as a computer security consultant, and writes this newsletter to assist others in their investing activities and to keep abreast of important issues in the equity and financial markets.

He has a weblog where he writes on these topics. The link is:

www.desertoftherealecononomicanalysis.blogspot.com

(Yes, “economic" is misspelled in the URL. But changing the URL would inconvenience the Author’s readers and some would lose the link.)
He may be reached by email at des
[1] The title of this Newsletter, “Welcome to the Desert of the Real”, comes from the 1998 film “The Matrix”. The world in the Matrix is a Simulacrum, a computer–generated illusion. It only “looks” and “feels” like the late 20th century. Instead, human beings are enslaved in tanks of fluid, wired to the Matrix. Also, readers steeped in post-structuralist philosophy may recognize the title as a paraphrase of a quote in Jean Baudrilliard’s 1981 book, “Simulacra and Simulacrum”.

[2] The Author continues to watch films at The Guild Cinema, the local art house in Albuquerque. A recent film was the re-release of “The Passenger”, a 1975 film by the pre-eminent filmmaker, Michelangelo Antonioni. The film stars a younger Jack Nicholson in the stark landscapes of North Africa and coastal Spain. The film has elements of the thriller and international arms sales intrigue. And it also features the ingénue of “Last Tango in Paris” fame, Maria Schneider. The Passenger is getting a limited national release, so it may be coming to a local cinema. See it if you can.
[i] We will use a gambling analogy because it is a good demonstration of “risk and reward”. Gambling is not the same thing as investing, however.
[ii] Except at the casinos, where they add one or two zeroes. These zeroes lower your odds of winning and make sure that the house always wins. This is the best argument one can make against gambling at a casino. It is statistically a game you cannot win.
[iii] The symbol of the ETF for this index is IWD. http://finance.yahoo.com/q?s=IWD If we were looking at another type of mutual fund, such as the Afterburner Tech Stock fund, we would compare it with an index of tech stocks.