What traders are watching 11/28/2016 – Dave Lutz

Greg Blotnick – What traders are watching 11/28/2016 – per JonesTrading

TRUMP TRADES– Donald Trump’s economic plans received strong backing[ft.com] from the Organization for Economic Co-operation and Development on Monday, with the international organization predicting the president elect’s infrastructure planswould increase US growth, combat inequality and energize discouraged workers.

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Boosting spending on infrastructure and improving education could relieve some of the burden on the US central bank to support the economy – Stanley Fischer, vice-chairman of the Federal Reserve Board, said[ft.com] well-targeted fiscal policies could lift America’s economic potential. About $500bn had gushed from equity funds and into bonds this year but last week the flows reversed[ft.com], with investors yanking more than $18bn from fixed-income vehicles and pouring $27.5bn into stocks, according to EPFR Global

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Industrial metals also remained red hot on hopes of strong demand for property and infrastructure investment in China and the United States – Chinese steel futures jumped over 6 percent, while iron ore futures also gained about six percent and zinc, used to galvanize steel, powered[reuters.com] to a nine-year high on the London Metal Exchange – China’s top economic planner today approved[bloomberg.com] a 247 billion-yuan ($36 billion) railway plan to link Beijing to neighboring cities as part of a government effort to improve connectivity around the nation’s capital.

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We need to look at month-end rebalancing.  Getting chatter $17-$27B of equities for SALE and Bonds to BUY by rebalancers.   “Largest since Oct 2015” says the Goldman.  Spoos + 5% MTD, TLT down almost 8% MTD

On Friday, investors turn their attention[ft.com] to the US for an update on the health of the country’s labour market. The US economy is expected to have created 175,000 jobs in November, from 161,000 the previous month. Economists expect the unemployment rate remained unchanged at 4.9 per cent, while average hourly earnings grew just 0.2 per cent in November, from the previous month, when they climbed 0.4 per cent.

MOONSHOT– Small company shares on Friday notch their longest winning streak in 20 years[blogs.wsj.com] on a shortened Black Friday trading session. The Russell 2000 Index rose 0.4% in in the shortened session to book its 15th advance in row. This streak ties a run last seen in February 1996. The longest ever streak, 21, was hit back in 1988.  Investors are betting that President-elect Donald Trump will relax regulations, lower taxes and pump money into infrastructure projects. Such policies should benefit small caps more than there larger brethren.


Warren Buffett’s Meeting with University of Maryland MBA/MS Students – November 18, 2016


Warren Buffett’s Meeting with University of Maryland MBA/MS Students – November 18, 2016

 (Notes primarily taken by Professor David Kass, Department of Finance, Robert H. Smith School of Business, University of Maryland.  Additional notes taken by Beija Fu, Yanting Ma, and Shiyue Wu were also included.)

Warren Buffett (WB) (age 86) met with 20 MBA/MS or undergraduate students from each of eight universities/colleges, including the University of Maryland, on November 18, 2016.  (The other seven universities/colleges represented were, in alphabetical order, Boston University, Columbia University, Concordia (Montreal), Grinnell College, Marquette University, St. Louis University, and Yale University.)   Mr. Buffett responded to 20 student questions over 2 ½ hours.

Prior to responding to the questions, WB mentioned that his hearing is not as good as it used to be.  He said that recently he stood across the room from Charlie Munger (age 92) (CM) and said “Let’s buy General Motors at 33, do you agree?”  Since there was no response, he moved closer and repeated the same statement.  Again, no response.  Then he went very close to CM and repeated his statement.  CM replied “for the third time, yes!”

WB also invited all of the students to Berkshire’s next annual meeting in Omaha.  “Since Berkshire has invested in airline stocks”, the students “should fly first class to the annual meeting”.

Question 1:  What qualities do you look for in hiring people?

WB: Berkshire has only 25 people at headquarters, but 360,000 employees.  The managers of Berkshire’s 70 businesses choose their own people.  The qualities they look for are intelligence, energy, and integrity.  But the most important quality in a manager is having a passion for the business.  It is not IQ but passion for their businesses that make Berkshire’s 70 managers stand out.  When WB was 23 years old, he was rejected by Ben Graham for a job. Years later he received a letter saying the “next time you come to NY stop by my office”.  WB went the next day.  He never asked about pay.  You should take a job that you would take if you didn’t need a job.

Question 2:  What is the percentage of S&P 500 companies that are getting better?

WB:  WB has been on the board of directors of 19 public companies.  3G Capital has added discipline to Kraft Heinz and Anheuser Busch InBev.  Jeff Bezos is the best business person he has ever seen.  The quality of management has improved and they are paid better.  The CEO’s main responsibility is capital allocation.  Director fees are now about $300,000 – $400,000 per year and directors generally do little.  Berkshire’s directors buy stock in Berkshire with cash (rather than stock options used by most companies).

Question 3Are you concerned by the size of the national debt?

WB:  The gross debt of the U.S. is 100% of GDP, but the net debt (subtracting trust funds) is less, at 70%+ of GDP.  Our net debt was as high as 120% of GDP in World War II and as low as 35% -38% in the Reagan years.  As long as our debt is in dollars, it cannot cause us any problems. (We can always print more dollars.)  Taxes have accounted for 16% – 20% of GDP over time.  Medical costs today represent 17% of GDP, up from 5% in 1970.  The next highest country spends only 11% of GDP on health care.  Corporate taxes equal 2% of GDP down from 4% in the past.

Question 4:  Question about Joe Rosenfeld (Grinnell College)

WB:  WB was a trustee of Grinnell College for many years and Joe Rosenfeld at Grinnell was a hero of Buffett’s.

If you know who someone’s heroes are, then you will know how they will turn out.

(WB also mentioned that the most important decision we will ever make is in choosing a spouse.  “If you want a marriage to last, marry someone with low expectations.”)

Question 5:  What is your opinion of active vs. passive management?

WB: Passive management is active management in aggregate.  The S&P 500 represents the aggregate result of America.  Nine years ago WB made a $1 million bet (for charity) on the Vanguard S&P 500 (very low fees) against a fund of funds (hedge funds).  The S&P 500 has substantially outperformed the hedge funds.  One-half of the gross returns of the hedge funds has gone to the managers.  They have underperformed by 40%.  The portfolio managers are getting rich while failing their investors.  Find well-managed companies that grow over long periods of time and leave them alone.  That’s mostly a passive approach.  Buy and hold.

Successful investors need to have the right temperament.  Those with high IQ’s frequently panic.

Question 6:  What is your opinion of Dodd-Frank?

WB:  We are less well equipped to handle a financial crisis today than we were in 2008.  Dodd-Frank has taken away the Federal Reserve’s ability to act in a crisis.  In 2008/9 Ben Bernanke said he will do whatever it takes and only he could have stopped it (financial crisis).  Money market funds equaled $3 ½ trillion or 50% of the $7 trillion of deposits in U.S. banks.  This could have been the “greatest run” of all time.  Ben Bernanke was able to draw from the Emergency Stabilization Fund set up in 1933 with respect to gold.   In 2008, President George Bush said the 10 most important words ever in economics:  “If money doesn’t loosen up, this sucker is going down.”  But Dodd-Frank took this option away from the Fed.  Fear is contagious.  It paralyzes.  Confidence comes back one at a time, not by a stampede.  Both General Electric and Goldman Sachs were “in the domino line”.   We were lucky we had the right people.

Question 7:  What impact have the fixed income markets had on stocks?

WB:  Interest rates are to asset valuation as gravity is to matter.  It will take a lot of movement in interest rates (similar to Paul Volcker in 1981-2) before stocks are too high.  The interest rates on 30 year Treasury bonds have declined from 14 ½ % to 2 ½ % from 1982 to 2016.  Recently, the 30 year Treasury moved from 2.6% – 2.8%.  Stocks are cheap if long term rates are at 4%, four to five years from now.  “We are buying more shares than selling everyday unless interest rates move appreciably higher”.  A profitable trade would be to short the 30 year bond and go long the S&P 500 (assuming no margin calls).  But this is difficult to do on a big scale.  Borrowed money causes more people to go broke than anything else. Charlie Munger has said, smart people “go broke from liquor, ladies and leverage”.

Question 8:  Question about Jamie Dimon and best practices for asset managers

WB:  Discussed this topic in conjunction with the Economic Club of Washington.

Question 9:  Why doesn’t WB invest in tech companies?

WB: Ted (Weschler) and Todd (Combs) each have about $9 billion to invest. One or more invested in Apple. With Apple, people get hooked on things that they like.  WB has a competitive edge within his circle of competence (which does not include tech companies).   His circle grows wider over time but outside of his circle tech people know better than he does.  WB mentioned that he did not invest in Microsoft even though it had no cost of goods sold and was earning a “royalty on the world” since the world needed its operating system.

Question 10:  Is there a fundamental (investment) wisdom that you disagree with?

WB: Investing hasn’t changed much over time.  There were 15 students in Ben Grahams’s class (where WB was an MBA student at Columbia).  He focused on cash over 2- 3 years and certain returns.  A stock is a bond with coupons on it.  Berkshire Hathaway is a stock with coupons attached.  Several years ago WB invested in 15 South Korean companies selling at two times earnings.  He didn’t know much about the companies except for their low valuations. He purchased a diversified portfolio.  It worked out very well.  If you invest in good companies, you do not need to diversify.  Anyone with an IQ above 130 should sell off the excess above that level.

Question 11:  If you started with $1 million today, how would you invest it?

WB: “If I had only $1 million today, then something has gone terribly wrong.”  Today, with $1 million, he and Charlie would probably invest in four stocks.  When he graduated from Columbia (MBA), he had 75% of his net worth invested in Geico (then called Government Employees Insurance Company).  He started his investment partnership in 1956 with $105,000 and it was worth $105 million when he closed the partnership in 1969/70.

Question 12:  What qualities do you admire in others?

WB: Choose someone (among your friends and classmates) whom you would want 10% of their future earnings.  Someone who is generous with a good sense of humor and you would want to be led by them.

Question 13:  What is your opinion of high frequency trading?

WB: High frequency trading does not bring anything to the world.  It doesn’t hurt Berkshire.  WB recommends a tiny transaction tax.

Question 14:  What impact have the central banks had on stock markets?

WB: Central banks have pushed down interest rates and have affected the whole world. Europe needed negative interest rates.  The Federal Reserve’s balance sheet was $1 trillion 10 years ago and is $4 trillion today.  If WB could be reincarnated, he would like to come back as Chairman of the Fed.  It provides the fourth largest source of receipts to the U.S. Treasury.  It paid dividends last year (to the U.S. Treasury) of $117 billion.   It is the largest hedge fund of all time.  Its net worth of $4 – $5 trillion consists of $2 ½ trillion in Treasury securities and the Fed is responsible for over 3% of U.S. receipts.  Central banks have never been more important and no one knows how this (negative interest rates) will play out.   Where there is chaos there is opportunity.

Question 15:  What are your views on Tim Sloan (new CEO at Wells Fargo)?

WB: One-third of the country does business with Wells Fargo (WFC).  WFC broke a bond of trust, but the number of depositors will be higher one year from now.  Its balance sheet is $1 trillion – $2 trillion.  Former CEO John Stumpf created an incentive system with perverse consequences.  He should have acted quickly, but he did not.  John Gutfreund at Salomon Brothers in 1989 also was slow to respond.  One should face up to a problem fast.  “Get it right, get it fast, get it over”.  WFC will do fine over time.  Berkshire has not sold any of its shares.  Charlie says: “an ounce of prevention is worth a ton of cure”.

Question 16:  Question about Ajit Jain and insurance.

WB: WB was very lucky in January 1950 when he took a train from New York to Washington, DC on a Saturday morning to visit Geico. Since his hero Ben Graham was chairman of Geico, he wanted to learn as much as he could about it. He knocked on the door and a janitor came out.  WB  didn’t know that people in Washington did not work on Saturdays (as they do in Omaha).  WB asked: Is there anyone here besides you?  Fortunately, an executive (who later became CEO), Lorimar Davidson, was there and then spent the next 3 – 4 hours explaining the business of insurance.  It transformed WB’s life.  Berkshire bought National Indemnity in 1967.  In 1986, Ajit Jain walked into his office on a Saturday.  Today, 30 years later, Ajit runs Berkshire’s reinsurance business and talks to WB every day.  Ajit “reinvents business hourly” (after 9/11) as compared to Geico which has had the same business model since 1936.  Ajit’s business will be very different 10 years from today.  Berkshire offers its employees $1 million per year for the rest of their lives if they can predict which teams will be in the “Sweet 16” in the annual March Madness (college basketball).  The average policy at Geico costs $1700/year.  Some Geico employees have 4 times the productivity of others (selling policies) over the phone.  “When talking to someone on the phone, put a photo of the person you love most on your desk and talk in the way you would talk to that person”.

Question 17:  Will technology replace human intelligence?

WB: Technology will not get rid of the human element of fear and greed.  You cannot program a computer to produce a durable competitive advantage nor create passion for employees. Berkshire is not at a disadvantage now.  WB prefers Ted (Weschler) and Todd (Combs) over computers.

Question 18:  What was WB’s biggest mistake and what did he learn from it?

WB: His initial three businesses are now out of business – (1) Berkshire Hathaway – textiles, (2) Blue Chip Stamps, and (3) Retail division – department store in Baltimore. He has made some “people” (hiring) mistakes.  The worst part of his job is having to terminate an employee.  He regrets “things I haven’t done even though I thoroughly investigated, but I didn’t do”. (Errors of omission rather than errors of commission)

Question 19:  Why has Berkshire invested in airlines?  Doesn’t WB avoid cyclical industries?

WB: WB will not discuss his recent investments.  But he almost lost a lot of money in US Air Preferred (1989).  For a while he could not sell his holdings for 25 cents on the dollar, but did end up selling it for 200 cents on the dollar years later and made a big profit.  Normally smaller positions (under $1 billion) are Ted’s or Todd’s.

Question 20:  What is the most important skill in finance?

WB: The most important skill in finance is salesmanship.  That’s how you convince someone to marry you and that’s how you get a job. The most important quality to do well is temperament which would permit the control of fear and greed which have ruined many.  Anyone who has become rich twice is dumb.  Why would you risk what you need and have for what you don’t need?  If you are already rich, there is no upside to taking on a lot more risk, but there is disgrace on the downside.

Finally, WB concluded by telling the students to “vote for me and not Charlie at the annual meeting.”




Sustainable Sources of Competitive Advantage by Morgan Housel

Another great post by Morgan who belongs in the pantheon of great financial journalists:

Sustainable Sources of Competitive Advantage

David Paul Gregg invented the CD, which is amazing and changed history. But you’ve probably never heard of him because CDs aren’t difficult to make, and lost relevance over time.

Most things work this way. As soon as a smart product or business idea becomes popular, the urge to copy it and commoditize it is the strongest force economics can unleash. Jeff Bezos summed this up when he said “Your margin is my opportunity.”

The key to business and investing success isn’t finding an advantage. It’s having a sustainable advantage. Something that others either can’t or aren’t willing to copy once your idea is exposed and patents expire.

Finding something others can’t do is nearly impossible. Intelligence is not a sustainable source of competitive advantage because the world is full of smart people, and a lot of what used to count as intelligence is now automated.

That leaves doing something others aren’t willing to do as the top source of sustainable competitive advantage.

Here are five big ones.

The ability to learn faster than your competition

Someone with a 110 IQ but the ability to recognize when the world changes will always beat the person with a 140 IQ and rigid beliefs. The world is filled with smart people who get nowhere because their intelligence was acquired 20 or 30 years ago in a vastly different world than we live in today. And since intelligence has a lot of sunk costs – college is expensive and hard, for example – people tend to cling to what they learn, even while the world around them constantly changes. So the ability to realize when you’re wrong and when things changed can be more effective than an ability to solve problems that are no longer relevant. This seems obvious until you watch, say, Kodak or Sears trying to solve 1980’s problems in the 2000s.

Marc Andreessen promotes the idea of “strong beliefs, weakly held,” which I love. Few things are more powerful than strongly believing in an idea (focus) but being willing to let go of it when it’s proven wrong or outdated (humility).

The ability to empathize with customers more than your competition

Forty-seven percent of mutual fund mangers do not personally own any of their own fund, according to Morningstar. That’s shocking. But I suspect something similar happens across most businesses.

What percentage of McDonald’s executives frequent their own restaurant as a legitimate customer interested in the chain’s food, rather than a fact-finding mission? Few, I imagine. How many times has the CEO of Delta Airlines been bumped from a flight, or had his bags lost by the airline? Never, I assume.

The inability to understand how your customers experience your product almost guarantees an eventual drift between the problems a business tries to solve and the problems customers need solved. Here again, a person with a lower IQ who can empathize with customers will almost always beat someone with a higher IQ who can’t put themselves in customers’ shoes. This was apparent in the recent election, when understanding the electorate’s mood far exceeded the power of traditional campaign strategies.

It’s also why the best writers are voracious readers. They know exactly what readers want and don’t want because they themselves are customers of content.

The ability to communicate more effectively than your competition

Business success doesn’t necessarily go to those with the best product. It goes to whoever is the most persuasive. George Soros may be one of the brightest minds in finance, but he would fail miserably as a financial advisor. Not one person in ten who reads his books understands what the hell he’s talking about.

Most business edges are found at the intersection of trust and simplicity. Both rely on the ability to tell customers what and why you’re doing something before losing their attention.

This is one of the crazy things that gets harder to do the smarter you are. There’s a bias called “the curse of knowledge,” which is the inability to realize that other people with less experience than you have don’t see the world through the same lens you do. I saw this firsthand when a financial advisor told an utter novice grandmother that a higher bond allocation (which she wanted) didn’t make sense “because of the slope of the yield curve.” She had no idea what this meant, and told me experiences like this eroded trust since she couldn’t distinguish her confusion from his obfuscation.

The willingness to fail more than your competition

Having no appetite for being wrong means you’ll only attempt things with high odds of working. And those things tend to be only slight variations on what you’re already doing, which themselves are things that, in a changing world, may soon be obsolete.

Here’s Bezos again: “If you double the number of experiments you do per year, you’re going to double your inventiveness.”

The key is creating a culture that allows you to fail often without ruin. This means not docking employees for trying things that don’t work, and not betting so much on a single idea that its failure could cripple the company.

Amazon and Google, I’m convinced, are successful because they’re better and more willing to fail than any other company. Accepting lots of small failures is the only way they’re able to eventually find a few things that take off.

The willingness to wait longer than your competition

Rewards sit on a spectrum: Small, unpredictable ones in the short run, big, higher-odd ones if you wait longer.

It’s amazing how much of a competitive advantage can be found by simply having the disposition to wait longer than your competitors.

Waiting longer gives you time to learn from, and correct, early mistakes. It reduces randomness and pushes you closer to measurable outcomes. It lets you focus on the parts of a problem that matter, rather than the chaos and nonsense that comes in the short run from people’s unpredictable emotions.

If you can wait five years when your competitors are only willing to wait two, you have an advantage that is both powerful and uncorrelated to intelligence or skill.

Which is about as close to a free lunch as it gets in business.


Wilbur Ross – Infrastructure Finance

The Trump Private Sector Financing Plan

The Trump infrastructure plan features a major private sector, revenue neutral option to help finance a significant share of the nation’s infrastructure needs. For infrastructure construction to be financeable privately, it needs a revenue stream from which to pay operating costs, the interest and principal on the debt, and the dividends on the equity. The difficulty with forecasting that revenue stream arises from trying to determine what the pricing, utilization rates, and operating costs will be over the decades. Therefore, an equity cushion to absorb such risk is required by lenders. The size of the required equity cushion will of course vary with the riskiness of the project. However, we are assuming that, on average, prudent leverage will be about five times equity. Therefore, financing a trillion dollars of infrastructure would necessitate an equity investment of $167 billion, obviously a daunting sum.

We also assume that the interest rate in today’s markets will be 4.5% to 5.0% with constant total monthly payments of principal and interest over a 20- to 30-year period. The equity will require a payment stream equivalent to as much as a 9% to 10% rate of return over the same time periods. To encourage investors to commit such large amounts, and to reduce the cost of the financing, government would provide a tax credit equal to 82% of the equity amount. This would lower the cost of financing the project by 18% to 20% for two reasons.

First, the tax credit reduces the total amount of investor financing by 13.7%, that is, by 82% of 16.7%. The elegance of the tax credit is that the full amount of the equity investment remains as a cushion beneath the debt, but from the investor point of view, 82 percent of the commitment has been returned. This means that the investor will not require a rate of return on the tax credited capital. Equity is the most expensive part of the financing; it requires twice as high a return as the debt portion, 9 to 10% as compared to 4.5 to 5.0%. Therefore, the 13 percent effective reduction in the amount of financing actually reduces the total cost of financing by 18 to 20 percent.


By effectively reducing the equity component through the tax credit, this similarly reduces the revenues needed to service the financing and thereby improves the project’s feasibility. These tax credits offered by the government would be repaid from the incremental tax revenues that result from project construction in a design that results in revenue neutrality. Two identifiable revenue streams for repayment are critical here: (1) the tax revenues from additional wage income, and (2) the tax revenues from additional contractor profits.



Zervos on Election

Key Points from David Zervos’ Post-Election Conference Call:

  • Market appears to be reacting positively to the calm nature of Trump’s victory speech (Trump focused on infrastructure and growth, not on deporting people and building walls), but David is not sure how long that attitude will last and he would not jump into EM currency at this time, nor into risk assets.
  • David had pointed to Brexit as an example of what could happen to the US dollar post-Trump, but he never expected the degree of weakness that we had seen with the GBP.  Seeing some modest weakness in the USD this AM, and though he wouldn’t jump back into EM currencies immediately, he does think there will be a time to get back in to those EM currencies.
  • The bulk of the move in rates this AM has been a result of higher breakevens, rather than real rates, and David expects real rates to drift lower.
  • There have been some concerns about whether the Chinese might devalue, but David doesn’t think that’s a big concern, not in the near/medium term.
  • He believes the mobility of capital and labor in the US will be in a restrictive environment for the next 3-5 years and that does not make him bullish on risk assets at this time.
  • Sees eventual potential for real rate differential trade (real rates in Latam being much higher) becoming interesting again as this plays out.
markets · tech

What Does Tracking Error Mean for Your Money? Greg Blotnick, CFA

Source: Greg Blotnick – What Does Tracking Error Mean for Your Money?

By Jeff Brown | Contributor

Nov. 7, 2016, at 9:00 a.m.

Investors who study their index funds closely eventually learn of tracking error – the difference between the fund’s performance and that of the underlying index it follows. Since index funds own the same securities as their benchmark indexes, there should not be much difference.


But aside from knowing that a small tracking error is better than a big one, is this something we should really care about?


“Ultimately, tracking error is one factor among several you should consider when deciding to purchase any index fund.” says Anthony D. Criscuolo, planner and portfolio manager with Palisades Hudson Financial Group in Fort Lauderdale, Florida.


In most cases, tracking error causes an index fund to do worse that it’s benchmark rather than better, and small reductions in returns can add up to significant money over many years of compounding.


And in some cases, the error can be enormous, says Greg Blotnick, a hedge fund equity analyst in New York. He notes the wide tracking error of exchange-traded notes designed to follow the CBOE Volatility index that measures volatility in the Standard & Poor’s 500 index.


The most popular examples are the iPath S&P 500 VIX Short-Term Futures (VXX), the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) and the ProShares Ultra VIX Short-Term Futures ETF (UVXY), he says. These products are designed for intra-day trading and hedging, not as long-term holdings. Some use leverage to amplify results, which can magnify losses.


“If you had invested $400,000 in UVXY when it was first introduced (several years ago) you would have less than $100 today,” Blotnick says.


Despite those examples, ETFs generally have very small tracking errors. That’s because fees are very low, and, since ETFs are traded like stocks, they do not have to buy and sell securities to meet investor purchases or sales, so it’s easier for these products to march in lockstep with their underlying indices.

Actively managed funds typically use market indexes as performance benchmarks. But because their goal is to beat the benchmark rather than mirror it, their holdings may be quite different from the benchmarks’ performance.


Do Actively Managed Funds Really Pay Off for Investors?

A potential for excellence also means higher fees.

While that’s a cause for concern if the managed fund trails its benchmark, this is simply poor performance and not the same sort of tracking error found in index funds.


“Actively managed funds do not attempt to duplicate an index,” says James B. Twining, wealth manager at Financial Plan in Bellingham, Washington. “Instead, they generally strive to outperform it. In other words, they seek tracking error on the upside.”


So true tracking error is mainly a worry for investors in index mutual funds and exchange-traded funds.


Usually, the chief culprit is the index fund’s fees, or expense ratio – money taken from the fund’s assets to pay for staff and other management costs, Criscuolo says.


“If an index fund operates at full efficiency, you would still expect the fund to trail its underlying index by however much it charges the investor in fees,” he says. “The underlying index has no fees, but the index fund does. All else being equal, a less expensive fund will have lower tracking error.”


Error also creeps in if the index fund does not actually own all the securities in the index it follows, he adds, explaining that this is particularly common in bond funds that include hard-to-get securities.


“Some index funds rely on sampling to save on trading costs,” Criscuolo says. “Sampling can introduce tracking error, positive or negative, into a fund’s performance. Similarly, funds that track relatively illiquid securities, such as commodities or currencies, face greater price volatility.”

Human error and plain old luck can also contribute, according to Nicholas Yrizarry, CEO of Nicholas Yrizarry Wealth Management Group in Laguna Beach, California. Rising markets can attract a flood of new investment in the fund, forcing the manager to buy more securities, affecting the fund’s costs, while the index itself does not buy or sell.


“Other common factors that affect tracking error are cash drag, rebalancing frequency of the underlying index, and securities lending by the index fund,” Criscuolo says.

Tracking error can clearly matter to big institutional investors trading very large volumes and fretting over even the tiniest price variations. But what about ordinary investors likely to hold an index fund for years, or even decades, for college or retirement?


Small investors are indeed wise to look for how tracking error may affect their results, Criscuolo says, noting that the simplest way is to look at the fund’s performance over time versus that of its index, figures available on fund company sites and data services like Morningstar.com. The more the fund’s performance lags the index’s, the bigger the problem.


For the past five years, the granddaddy of index funds, the Vanguard 500 Index Fund (VFINX) returned an average 13.38 percent a year, while the S&P 500 returned 13.54 percent, according to Morningstar. That small difference is almost entirely explained by the fund’s 0.16 percent expense ratio.

Meanwhile, the Rydex S&P 500 Fund Class A (RYSOX), tracking the same index, returned just 11.70 percent a year, trailing the index dramatically. The chief cause: a 1.55 percent expense ratio, a whopping charge for an index fund.


Why do people buy expensive index funds with large tracking error when there are better alternatives? Either they’re not looking closely or their advisor has talked them into it. The Rydex fund also charges a 4.75 percent load, or $4.75 for every $100 invested, to cover the advisor or broker’s sales commission. The Vanguard fund, and many from other firms, can be purchased directly from the company with no commission.


Investors who want to get into the details of tracking error can look at figures like R-squared, a measure of how well the fund’s movements track the indexes, and Beta which shows how the fund’s risk compares to that of the index, Criscuolo says.

While tracking error is a minor disappointment with most index funds, it can be catastrophic in extreme cases, and is a window into how well the fund is managed, and whether the fund is providing all the efficiencies indexers promise. With managed funds, it shows whether the managers have drifted away from their game plan. Among funds that are similar in most respects, the one with the smaller tracking error is generally the best choice.

dying industry · markets

RBC’s McElligott – Big Picture

OVERNIGHT / MACRO: Chief Risk Officers still in charge of trading books apparently, with DAX and Estoxx -0.9% so far today / SX7E EU Banks -5.5% on week as crowded tactical longs built in recent weeks are purged, NKY -3.1% on the week, CL1 through $45 cleanly to the downside, $/Y under 103 and shorts from Yuan to GBP to USTs being covered in front of next week’s obvious event risk, as the lessons from the Brexit vote (outlined in the “RBC Big Picture” yesterday) are mechanically applied.

greg blotnick - LS equity index.jpg

Rates have gone from “THE” story to complete background, banging-around the gravity of the 1.80 absolute level as leveraged fund shorts are covered into the ‘risk-off’ move of late, but aren’t terribly-squeezed as the overseas real $ demand drivers are largely ‘hand-sitting’ until after the election.  That said, the UST curve steepening has been real of late (2s10s, 2s30s and 5s30s all through their 200dma’s to the upside).  As suchwe see that S&P Financials are the only sector that quarter-to-date is positive at +1.1%.


This lack of a larger more meaningful fixed-income rally against the risk-asset selloff is clearly a negative performance driver for risk-parity funds, while too we can assume that shorter-term ‘vol control’ allocation models continue to drive negative price impact via their stock weightings (sliding allocation / leveraging scale), as spot vol’s grind higher saw a larger ‘grabbier’ move yesterday.  5 day realized SPX vol has traveled from 1.385 last Friday (pre FBI) to yesterday’s closing level at 5.0…for relativity, that’s a not-so-chillaxed +261% move in five sessions.


Despite that fact that nearly every discretionary trader I speak with wants to “buy a Trump sell-off”, it’s painfully ironic that the de-risking driver revolves around this ‘constant re-pricing’ of Trump’s odds higher / tighter.  I laid-out the thought process around trading various election scenarios yesterday so I won’t delve back into that…but I will say that speaking with folks who embedded with polling-dynamics / polling-analytics teams, the recent and profound momentum-swing into Trump from HRC is a force that is exceedingly difficult to stop this close to “go time.”  As such, there is a real belief by many that key bell-weather States of Nevada, Ohio, Iowa and Nevada have tightened / shifted in his favor “real time.”  Add in similar observations in Pennsylvania, and you could suddenly get to the required 270 electoral college votes.  Based on this ‘coin flip’ bringing back the Brexit memories, CRO’s have to take books down aggressively and unemotionally so as to avoid ‘accidents’ come Wednesday….even if the qualitative muscle-memory and intuition tells them that Trump would likely ultimately be a tactical “buy.”


Unfortunately this morning, we have “this” bleeding into the fragile investor psyche on top of already jangled nerves: Sources: U.S. intel warning of possible al-Qaeda attacks in U.S. Monday.”  And worth reiterating from yesterday’s note: on top of the increasing sense that this current US election risk-event overhang will linger for weeks and months to follow, we catch another reminder of “what’s to come” between now and year-end, as just now, we get this headline: Italy Referendum: Yes 38%, No 39%, Undecided 23%: Ixe Pol.”


THE CURRENT INSANITY OF SINGLE-STOCK BEHAVIOR: Apologies to pure macro readers for so much stocks focus of late, but it continues to be accurate to say that all of the action is taking place in equities right now…and stick with me, because there is  some good macro thought-below.  Man was yesterday a bizarre one in US equities….and even stranger, it’s happening in a relative vacuum, as the rest of the macro / cross-asset universe is lulled to sleep with much tighter ranges on the day..


The behavior in equity vol is one thing (as tails were massively bid yesterday—SPX 1m 80% moneyness was +10.2% on the session, while ‘vol of vol’ is now +34 vols / +40.1% over the past 8 sessions)…but the price-action in single-stock was the stuff we haven’t seen since the Q1 market-neutral factor unwinds ripping through the pod-shops…where for a stretch in late Jan / early Feb, teams / books were being blown-out on daily basis around the Street.


Back then, it was ‘bad-positioning’ from the buyside based on macro impact on style factors.  1) Everybody came into January ‘16 long growth & momentum (and thus, “high beta”), aka “story stocks” in tech and discretionary, along with major healthcare sector overweights (biotech / spec pharma / generic drug makers).  Similarly, there was a huge belief in “short bonds” to start the year too–as seemingly the Fed’s long-awaited rate-hiking cycle had just begun the month prior–as such, 2) there was a massive long in financials / banks on expectations of higher rates.  And to put the cherry on top, 3) there was a major quant / stat arb long in energy, anticipating a January ‘mean reversion’ (a tried-and-true back-tested phenomenon).


In hindsight, it is absolute insanity how ‘bad’ that all was—you couldn’t construct it any worse.  As such, the pain trade “went to 11,” as risk-assets were purged under the weight of the deflation scare: China came out of the gates with further Yuan devaluation, crude was -10% on the month, and UST 10Y yields were absolutely obliterated, moving from 2.30 the last day of Dec ’15 to 1.65 by Feb ’16. With all of this, growth and momentum came unglued, the move lower in rates not only crushed bank longs but also too saw a massive rotation into the (dreaded) ‘bond proxies’—‘low vol’ factor, dividend yield, defensive sectors.  You know the rest…


So fast-forward to now: what’s so incredible about the behavior witnessed over the past few days ‘under the hood’ is that relative to all of our recent drawdowns being so clearly macro-driven (deflation / reflation events of the past two years—Yuan deval, crude spasms, Yellen “weak USD policy pivot” / “Shanghai accord,” CB coordinated messaging on “curve steepening” intent, the inflation impulse bond-beatdown etc)…is that this equities move started as simple “de-risking in front of a ‘fluorescent swan’ of a binary US Presidential election”…that has now crescendo’d into a really bad VaR outbreak.


While on the benchmark index level we saw a “barely a paper-cut” 9-handle move in SPX yesterday(-0.4%)…we saw 29 US Composite names with market caps north of $25B dollars which traded -1.5% or (much) greater on the day—heavy-hitters like Kellogg, Apple, AbbVie, Humana, Liberty Global, Intel, Kraft Heinz, Charter Comm, Constellation Brands, HCA Holdings, Starbucks, Target, Anthem, Pfizer, Estee Lauder, Amgen, Lockheed Martin, CVS Health, Kroger (-3.7%), AIG (-4.0%), Allergan (-4.0%), McKesson (-4.6%) and index mega-weight Facebook (5th largest weighting in SPX, -5.6% on day).  Other popular longs like CHD (-6.6%) and THS (-19.5%!) got smoked too, while more idiosyncratic political drama crushed the generic drug maker space, with PUNISHING capitulation in MYL (-7.0%), ENDP (-19.5%) and TEVA (-9.5%) amongst others.


The tech sector has been “THE” hiding place recently for investors, on account of folks getting increasingly nervous about riding their cyclical longs much further here after the run they’ve been on (and crude rolling over sharply -9% on the WTD as the OPEC “deal” looks like anything but)–but also being hyper-cognizant of the inflation base-effect’s lagging-impact on bond prices (higher yields) and purportedly a Fed still committed to a Dec hike (with a steady-state world of course) makes putting back on the ultra-expensive ‘bond proxy’ / ‘low vol’ factor / defensive trade look quite unattractive as well.  So despite tech being such a ‘stud’ recently (XLK +10.2% in Q3), it’s received the ‘rented mule’ treatment as effectively an “ATM” of late (with ‘FANG’ -4.4% over the past 5 sessions, XLK -2.6% over past 5 sessions). 


But maybe the strangest thing experienced was seen amongst seemingly popular and thus theoretically winning short positions, where we saw huge outlier downside moves—BW (-10.3%), FSLR (-15.0%), FIT (-33.6%) and DPLO (-42.1%).  This is simply abnormal.  How do I rationalize this?  Well in ‘max pain trade’ fashion, I think that sadly many had actually given-up on these shorts over the outrageous daily-grind higher period in Q3—remember, SPX was +3.3% on the qtr, Russell 2k was +8.7% and (drumroll please….) the GS Most Shorted Basket was +14.5% on the quarter.  So what we’re seeing this week is that the right ideas that folks once had on in their short books—but were forced to capitulate on during the face-ripping rally in Q3—actually saw their short theses play-out to a tee.  The companies reported terrible quarters, and as such, were promptly hammered and punished / re-deployed by guys who originally had the trade right…but had sadly ‘tapped out!!!’  Just gutting stuff…


Ironically though this time around, we see equity market neutral funds performing very well relatively speaking to long-short or long-only.  take a look at one widely followed quant’s open-end market neutral fund against the HFR Equity Long / Short Index, ‘High HF Concentration basket’ and ‘Mutual Fund Overweights’ baskets over the past two months:



Charlie McElligott – Food For Thought

Dropping the overnight cacophony of noise out of UK Brexit rulings, ECB headlines and US poll updates…I want to instead discuss trader mindset over the past week and into next week and thereafter.


ELECTION SCENARIO FEEDBACK: I have spent the vast majority of the past week engaging some of our brightest clients in my feedback loop on (completely unsurprisingly) US election scenarios.  Here are a few key bulleted observations:


–Overall largest take-away was that this de-risking in stocks has been so orderly and grinding due to the buyside’s lessons from underestimating Brexit possibilities in June, EVEN THOUGH the odds are still in the favor of the perceived “market positive” HRC outcome.  This de-risking is thus a “slow-bleed” and not a panic-grab, as Brexit was much closer to a true “toss up” going into the vote, versus this still likely ’70 / 30’ probability for HRC.  Recall, folks were taking nets HIGHER days into that event-risk.  As you’ll see below, the performance of thematic baskets in my monitor yesterday shows that longs have been taken-down rather precipitously (although somewhat surprisingly that some shorts are currently being added to as highlighted in recent days).  I would add another complication is the timing with “peak earnings” idiosyncratic risk, which has been showing us a number of outsized price reactions, and as such is adding to an overall desire to ‘gross down’ over the longer past week time frame.


From a vol perspective, for net exposure at HFs to be cut so low so fast, and for cash to be so high now at MFs heading into the event, it makes some sense to me that there is less “panic grab” for VIX upside simply because folks aren’t all that long / don’t have that much to protect now.  That said, there are certain products and lines where the vol is rich and straddles are pricing in some large moves which I will touch-on later.  And also pretty simply, as VIX is calculated based upon 4th and 5th week SPX options strip…and as this is a ‘one week out’ event, it’s just not being “picked up.”  Thus “VOL OF VOL” (VVIX, convexity) is showing far greater relatively movement than the “underlying” VIX.  As such, “vol of vol” is probably the best sale of all (sell VIX straddles).


–Outcome-wise, all were of consensus view that you can now throw-out the ‘risk’ of a Democratic sweep…a scenario that was a very real threat as of last week at this time.  Too much momentum has been lost in the past week.


–Ironically (with regards to the swing from one end of spectrum to other), there now is a view that the seeming momentum in the Trump camp could actually create a scenario that was previously “zero delta” which is now a “non-zero” probability of a “Trump Presidency / GOP Congress” regime could produce a “right tail” economic scenario–where the tax plans and deregulation movements could get more economically provocative for both individuals and small businesses.  Again though, this remains low probability.


There was a relatively widespread view that in the case of an HRC win (where the probability was perhaps ‘down to’ 60 / 40 yday, although some might say that lack of further surprises and even stabilization per the new earlier-referenced WaPo tracking poll would see that more like a return to 70 / 30 odds in her favor as of today), that there might be a +2% upside from here on a relief-rally, as markets would essentially claw-back what has been lost over this very calm de-risking bleed. 


–There was dissent on “where to from there (an HRC win)” as a number of folks are pushing outright “return to bull market” case—with this moving from a ‘rates / monpol’ focused equity backdrop transitioning to an ‘earnings-driven’ one.  My pushback there remains that earnings probably haven’t moved the needle enough to re-rate stocks against the headwind that comes in the form of higher rates and their impact on the ERP.  Equities still feels “stuck” to me, even after a likely ‘relief rally.’


–Regarding a Trump win, there was some debate on the next day SPX drawdown (-2% to -3% was the general ‘max’ view, with one outlier -5%), but nearly all agreed that there was a desire to ‘buy it.’  One would come from perceived “Brexit FX benefit,” i.e. that if the Dollar re-rated rapidly lower (essentially a devaluation) that US exporters would see the equivalent benefit (which was what we saw with Brexit and FTSE of course).  The other inputs here are of course the “steroid shot” of both the tax cuts on consumption / demand, the potential for de-regulation, and of course the GDP-kicker that is a massive deficit-spending infrastructure build program.  Other views are too that if bonds were to rally on “risk off” that it makes sense to sell it (especially with the growthy / inflation-inducing policy to come), while others thought that any USD kneejerk lower should also be bot on account of longer-term potential repatriation of overseas corporate cash (part of Trump platform during election), as well as potential for big data looking a year out under the regime.  That said, all were in agreement as to the eventual very bad hangover to follow from this debt binge while cutting tax receipts and not touching entitlements.


So outside of this feedback exercise….what is always a trade of interest to me is a ‘risk reversal’ or generally asymmetrical ‘skew buying power’ trade with stock index (selling one 10% otm SPY put to finance a buy of almost 19 10% otm calls!!!) into an environment where there is a rush for protection…as evidenced currently by the front-end of the VIX curve inverting, with Nov over Dec now.  Add in the overall portfolio de-risking we have been seeing, high cash / low net exposures, rapidly collapsed sentiment as contrarian ‘bullish’ indicators—in conjunction with ‘positives’ like a pick-up in global growth (Manu PMIs) and earnings trajectory—and it seems like a pretty obvious set-up for a ripper of a rally following the election.
But here is where I struggle with this idea of “fitting” a further rally into Q4: I am increasingly concerned that a relief-rally following an HRC election scenario might be somewhat short-lived due to so much overhang: outstanding FBI investigations in the air and legal noise on ‘contesting the vote’…i.e. this isn’t going away.  I also think that if you look at the ‘windows’ to put on ‘pro-risk’ trades between now and year-end with the US election (and whatever follows), the Dec Fed hike determination, the Italian referendum, now the British Supreme Court “Brexit / Article 50 Appeal” et cetera, you end up with a lot of idiosyncratic event-risk for a fragile buyside psycheThe sequencing and thus the risk / reward isn’t extremely compelling attractive.  When I then add this to anecdotal feedback from many funds I speak with, who are verbalizing a desire to ‘end the year now’ and ‘protect gains’ (predominantly made in Q3 to get back into “up mid-single digits YTD”), I just don’t know how much willingness there is to chase or put on new risk.  That said, surviving and starting a new year ‘fresh’ in Q1 WOULD be a new opportunity to pivot more ‘risk proactive’ again. 


One observer at a macro dinner I participated in last night stated that although he understood this view on “Q4 rally reticence,” he also thought that that same Q3 performance claw-back which got many funds back to “up lower to mid-single digits” YTD has now seen a couple percent shaved off of that with the friction “getting out” over the past week.  As such, this person believed that funds sitting near zero then WOULD BE candidates to prep for performance chase into this “seasonality / buyback resumption / election relief / under-positioning / over-bearishness” rally scenario. 


It’s all food for thought.


Third Point 2016 – Letter/Outlook

Third Quarter 2016 Investor Letter Review and Outlook


Third Point returned approximately 5% during the Third Quarter, outpacing the S&P 500 index by 1% and the CS Event-Driven index by 2%, with approximately half the net equity exposure. Results were driven by profits in each of our sub strategies – Equities, Sovereign and Corporate Debt, Structured Credit, Risk Arbitrage, and Privates – and also in each geographic area in which we invest globally. We generated alpha in each month of Q3. Despite a difficult year for hedge funds generally and a challenging start to the year for us, we have delivered positive returns for the year to date.

Our results have been driven by a number of idiosyncratic opportunities that we have invested in over the past six months and we see more of the same types of ideas in our pipeline. Trading and portfolio construction have required a strong constitution this year. The “haunted house” market coined by the late JP Morgan legend Jimmy Lee over 18 months ago has continued throughout this year with a constant string of macro “surprises.” A significant share of our time is spent deciphering the chatter to identify the most relevant “key” that will tip market risk and adjusting positioning accordingly. This year, our research led us to transition away from the short China / long Dollar bet in mid-Q1 and go long energy credit and out-of-favor industrial commodities-related equities. Later in the year, we responded to Brexit by covering shorts during the post-vote panic and increasing long exposure.

Today, we are focused on a few key areas: • Understanding the global shift from monetary to fiscal policy: monetary policy’s effectiveness is waning, which will impact bond yields. This influences our overall views of market valuation as well as sector allocation considerations. 2 • Will fiscal expansion become the new world order? While it seems logical and timely, it is challenging considering the very high debt to GDP levels globally. However, fiscal expansion could be an antidote to rising populism around the world which might smooth the way towards stimulatory infrastructure measures at home and abroad. One caveat is that not all countries have the flexibility to pursue such measures. • While China has fallen temporarily off the radar screen, we still see reasons for concern. The stabilization in economic activity has come at the cost of increasing leverage and a potentially overheated housing market. Political change next year may also result in increased volatility.

• We are clearly in the late stages of a business cycle following an eight year (tepid) expansion. While we do not forecast a financial crisis or a recession, a clear path to growth seems elusive. Consumers have been reducing spending and businesses have never regained their pre-2008 capital investment levels. We might soon long for 2% GDP growth. • Earnings have stalled for a few years and while this can be partially explained by falling oil prices, a strong dollar, weak global growth, and flat margins, earnings estimations may be inflated at these levels. This last observation dovetails with both the opportunity and the challenge we face investing today. We have seen a return to a “stock-pickers” market this year. However, that term does not mean what it did fifteen or twenty years ago when we were in our infancy. Then, picking stocks could be done in a virtual bubble and all of our time was spent deep in financial statements.

While our analyst team still spends the vast majority of its workday analyzing fundamentals, getting overall portfolio positioning right is equally essential to generating returns. The macro considerations discussed above must be interpreted correctly and applied successfully. When we add in the use of data sets and “quantamental” techniques that are increasingly important to remain competitive while investing in single-name equities, it is clear that our business is rapidly evolving. 3 We often focus on disruption when generating investment ideas; just as Uber has disrupted the taxi and car rental industries, Amazon has changed retail, and Facebook and Google have altered the print media business, disruptions are also changing investing. While some doors have closed, others are opening. We believe that maintaining our opportunistic and nimble framework has allowed us to transition successfully into this next phase. Our democracy has also been meaningfully disrupted this year.

Social media, primary processes built for the pre-internet era, and illegal foreign cyber-attacks have changed the trajectory of our political system. We try to analyze all of these political and economic events in a dispassionate manner, separating our feelings from what we think the impact will be on the economy, markets, and certain industries. Maintaining such emotional distance has been particularly difficult during the most disappointing and bizarre election in our country’s history. While many important issues affect the next president, from the appointment of a Supreme Court Justice to policies on education, healthcare, immigration, and the environment, we are focused on a few basic questions: What can we expect for economic growth in the coming years and do we face a recession? What is the prospect for monetary policy and where can we see long and short term rates? What impact will rates, productivity changes, and earnings expectations have on multiples? It is too soon to have answers to these questions and we may see surprises on Election Day.

Our short-term base case is for more of the same. This translates into a decent environment for Third Point to find special situations in equity and credit markets and make long-term bets on outstanding companies. Quarterly Results Set forth below are our results through September 30, 2016: Third Point Offshore Fund Ltd. S&P 500 2016 Third Quarter Performance* 5.0% 3.9% 2016 Year-to-Date Performance* 7.2% 7.8% Annualized Return Since Inception** 16.0% 7.4% *Through September 30, 2016. ** Return from inception, December 1996 for TP Offshore Fund Ltd. and S&P 500. 4 Portfolio Positioning Credit Update: Dell and Sprint In addition to Argentine sovereign bonds and energy-focused credit, we have also profited this year from several opportunities to add performing corporate credit exposure. Performing credit is interesting to us from time to time; we typically search for total return opportunities rather than screening only for yield.

We will often look for longer duration bonds in a company we believe has a visible catalyst for an improvement in its credit profile. We are able to create these dislocated positions quickly – before the market catches up – by building on deep fundamental research performed by our sector specialists who work in conjunction with our dedicated credit team. Dell Inc. and Sprint Corp. are two examples that have stood out as top winners this year. During the Second Quarter, Dell announced a large bond issuance to finance the acquisition of EMC Corp. While the Dell issuance is not a situation that would traditionally be popular with event-driven or distressed credit mandates, we believed market dynamics led the deal to price ~200bps wider than where we valued the bonds. Following its own LBO in 2013, Dell significantly improved its business through a variety of operational improvements and cost cutting initiatives. We believed the company would follow a similar playbook with the EMC acquisition and that the pro forma company would be a market leader in several areas including external storage, integrated infrastructure, and server virtualization software.

Dell has stated a goal of achieving investment grade ratings within 18 – 24 months of the acquisition, setting a path to tightening in long duration bonds and to attractive returns for our portfolio. Sprint has been another of our best performing investments this year. We were able to initiate our position at an attractive entry point in Q1 amidst the energy-driven dislocation in the credit markets and after the bonds were downgraded in February over concerns about Sprint’s near-term corporate debt maturities. We believed we were protected on the downside since the company has minimal outstanding senior or secured facilities and could likely issue new bonds higher in the corporate capital structure to refinance the pending 5 maturities. The company is also continuing to improve its business by strengthening the network in key areas, growing the subscriber base, opportunistically incorporating strategic partnerships, and executing an attractive cost of capital cycle.

Private Investments Third Point Ventures (“TPV”) was created in 2000 and currently invests in Technology, Healthcare, and FinTech companies at various stages. TPV receives all of its capital from Third Point’s funds and does not currently take outside dedicated investments. TPV’s aim is to produce superior risk-adjusted returns while adding perspective, ideas, and insights to Third Point’s general research efforts. We have found that being able to invest across the arc of a company’s life, from start-up through each stage of growth to pre-IPO funding rounds, has enhanced investor returns by exposing us to innovative new companies and thinkers. Our role as board members of these companies has introduced us to other Silicon Valley leaders, broadening our network and deepening our knowledge. While our two full-time TPV employees sit in our Menlo Park office, private investments have been sourced throughout the firm across our technology, ABS, distressed, and healthcare teams in New York. We have a significantly higher bar for such investments given their restricted liquidity and have limited overall fund exposure to 10% of NAV.

Of the 41 TPV investments made to date, 14 generated positive returns upon exit and 21 are currently active. Our current portfolio consists of 12 Technology investments, six Healthcare investments, and three FinTech investments. Privates currently represent ~6% of total portfolio exposure and we expect two of our larger investments to IPO in the next 18 months. Two of our portfolio companies, Apigee Corp. and Akarna Therapeutics Ltd., have contributed to returns this year and we have included more information about them below. Apigee TPV initially invested in Apigee in July 2008 when the company was known as Sonoa Systems. The company originally targeted their hardware appliance-based technology at Systems Oriented Architecture (SOA), challenging the industry-leading IBM as enterprises 6 quickly developed to connect application elements over networks. After recognizing in 2010 that there was a transformational opportunity to apply Sonoa’s core technology, Third Point Ventures helped the company rebrand itself as Apigee and pivot to a focus on enterprise digital transformation via a software platform for APIs (Application Programming Interfaces).

Since then, APIs have become the highway for the fast-moving digital economy. Apigee’s industry-leading API platform enables enterprises to meet the demands of customers with scalable and flexible digital technology. API platforms allow businesses to increase innovation while adapting to highly variable customer needs by securely providing shared data and services. The Apigee Edge API Management Platform connects digital experiences in a secure environment. Apigee’s API platform delivers analytics, security, developer portals, monetization, and policy enforcement. Since 2010, over 300 leading global enterprises have selected Apigee to enable their digital business, including more than 30% of the Fortune 100, four of the top five Global 2000 retail companies, and five of the top ten global telecommunications companies. The benefits of interacting digitally drive a large market opportunity. Forrester predicts that U.S. companies alone will spend nearly $3 billion on API management by 2020. Apigee now employs approximately 400 people. Drawing investors with its attractive growth profile, Apigee completed a successful initial public offering (NASDAQ: APIC) in April 2015. On September 8, 2016, Google announced their intention to acquire Apigee for $625 million in cash. Pending approvals, the transaction is expected to close later this year. Over an eight year period, TPV steadily assisted and guided the company as we invested in the Apigee Series B at $25 million valuation and the Series C, D, E, F, G, and H financing rounds before buying into the IPO. We have not sold shares and have remained active on the Board continuously since our first investment. Following the conclusion of the pending transaction, Apigee will have generated an IRR of ~20% and a multiple of invested capital of 2.4x. 7 Akarna Therapeutics TPV was a founding investor in Akarna in Q1 2015. Akarna focuses on the treatment of Nonalcoholic Steatohepatitis (NASH), also known as fatty liver disease. Akarna was attractive for several reasons: