Tuesday, 31 March 2009

ETFs are ruling

Exchange traded funds have become the dominant investment vehicle. Joshua Lipton of Forbes.com wrote the following story:
Despite last year's market crash, there were 160 new exchange-traded funds launched vs. the introduction of just 21 new mutual funds. At the same time, in 2008, net inflows into U.S. equity exchange-traded funds were a positive $120.8 billion vs. $162.4 billion net outflow for U.S. equity mutual funds.

ETFs keep gaining market share at the expense of mutual funds. Since their introduction in 1993, ETFs have exploded in popularity. As of early 2009, there are now 737 ETFs offering diverse investment strategies, everything from shorting gold to going long on Malaysia. Already "actively" managed ETFs have made their way onto the scene. From 2005 through 2008, ETF assets rose 77% while non-ETF mutual fund assets climbed 9%. ETFs now account for a whopping 40% of all index fund market share. By some estimates, worldwide ETF assets, now at $725 billion, should eclipse $1 trillion within two years.
It seems ETFs are taking Jack Bogle's index mutual fund religion to the extreme. Until recently, fund companies argued that ETFs were merely tools for hedge funds and other institutions. However, ETFs with their liquidity, transparency and cost efficiency are making their way to frontline investors. In fact, among a recent survey of Registered Investment Advisors by Charles Schwab, a full 79% say they now look to ETFs as their top investment vehicles for their clients.
The question for firms that rely on assets in actively managed mutual fund firms is how to compete and regain their luster during this attack of the ETFs.

The first line of counter attack will employ the "if you can't beat em, join em" approach. Expect more mutual fund shops to offer ETFs themselves to investors. Already, of course, companies like Vanguard are very actively involved in dishing up a wide array of ETF products. Vanguard, which launched its first ETF in May 2001, now has $45 billion in ETF assets. And it's continuing to roll out new products: Its 39th ETF--the Vanguard FTSE All-World ex-U.S. Small-Cap ETF--begins trading in early April. Fidelity introduced its first ETF, the Fidelity Nasdaq Composite Index Tracking Stock Fund, in 2003. It's also on a short list of potential acquirers of Barclay's massive iShares.

Friday, 27 March 2009

Is the economy turning the corner?...No! Not for me!

The latest unemployment figures confirm the extent of the recession in America. Rex Nutting of MarketWatch, wrote the following story:

Anyone who thinks the economy has turned the corner ought to talk to one of the nearly 8 million Americans who are getting unemployment benefits after losing their jobs.

They have plenty of time to talk to you.

The Labor Department reported Thursday that first-time claims for unemployment benefits rose by 8,000 to 652,000 on a seasonally adjusted basis. The number of people collecting state benefits increased by 122,000 to a record 5.56 million, again on a seasonally adjusted basis.

It was the third consecutive week that continuing claims rose by more than 100,000, a strong signal that hiring is anemic.

The raw numbers, not seasonally adjusted, are even worse, with 6.4 million collecting state unemployment benefits, and an additional 1.4 million who were collecting the federal benefits that go to people who've been fruitlessly looking for a job for more than six months.
The claims numbers don't show the whole story.
About 4 million more people are officially unemployed but not eligible for jobless benefits. In addition, 8.6 million can find only part-time work and another 2 million have given up looking for work. Nearly 15% of the workforce is unemployed, underemployed, or just plain discouraged.
The economy has lost more than 4 million jobs since the recession began, and about 3 million since the crisis deepened in September.
Unfortunately, job losses look to continue for the foreseeable future. Some economists suggested payrolls would fall by about 700,000 in March and the unemployment rate could climb to 8.5% from 8.2% in February.

Wednesday, 25 March 2009

World leaders: Watch out!

George Soros, the famous hedge fund manager, has expressed concern that the world's policy-makers have not responded correctly to the lessons of the current economic turmoil which in turn will lead to more trouble in the future.

etfexpress published the following story on 25 March 2009:

Yesterday the chairman of Soros Fund Management said that the financial crisis had proven that the idea of self-correcting markets was false and that it was dangerous to leave asset bubbles to deflate spontaneously.'Markets, far from reflecting the underlying reality accurately at all times, are always distorting it,' he told participants at the Wall Street Journal's Future of Finance Initiative. 'We have to recognise that, because of that, you can go very far in initially self-reinforcing, eventually self-defeating, boom-bust cycles, or bubbles. Therefore, you can't leave the markets to correct themselves.'
Soros argues that the downturn has driven the final nail into the coffin of the efficient markets hypothesis, which contends that the state of markets fully reflects all the information available to participants.'What has happened is that the efficient market hypothesis has been discredited, the evidence is just too overwhelming,' Soros told The Australian recently.
'But instead of accepting reflexivity, the [economics] profession is veering towards behavioural economics and what is called the adaptive systems or adaptive markets hypothesis. And I am worried about that, because I think that this will perpetuate the mistake.'
Soros also insists that policymakers need to distinguish between the two issues of stopping the collapse of the financial system and fixing its fundamental problems, arguing that the solutions are 'diametrically opposed' to each other.

Tuesday, 24 March 2009

Getting rid of toxic assets

US Treasury announced the ambitious $1trillion plan which boosted market confidence that a solution to the financial crisis is after all possible. Greg Robb, senior reporter for MarketWatch, wrote the following story:

After months of delay, the Treasury Department detailed a plan Monday to clear out as much as $1 trillion in so-called toxic assets from the financial sector in an effort to strengthen the banks enough to get them to lend again.

The public-private plan would have private investors and the Treasury put in equal amounts of money that would then be backed by a loan guarantee from the Federal Deposit Insurance Corp. to buy loans and mortgage-backed securities from the banks.

Both the taxpayers and the private investors would gain from any profits if the assets eventually gain value. The taxpayer would take most of the downside risk.

The plan is considered the linchpin of the government's strategy to get the financial system working again to provide the credit the economy needs. Since the credit crunch intensified in September, millions of jobs have been lost and the economy has contracted at the fastest pace in decades. The fallout from the U.S. banking crisis has spread around the globe.

The assets are considered "toxic" because the market for them has dried up as home prices have plunged. Banks are unwilling to sell the loans and securities for pennies on the dollar, and investors are cautious about overpaying for assets that might become worthless. In the meantime, the banks have reduced their lending because their required capital is worth less than they thought.

The Treasury plan is an attempt to give both the banks and potential buyers an incentive to make a deal.
The reaction was highly favorable on Monday. Stocks jumped on Wall Street on optimism that the plan would work. Banks stocks in particular gained.

The plan offers "the best prospect for a financial recovery," said Lawrence Summers, top economic adviser to President Barack Obama.
"The goal of this program is to restart the market for legacy securities, allowing banks and other financial institutions to free up capital and stimulate the extension of new credit," the Treasury said in a news release. The plan was designed "to make the most of taxpayer resources."

Geithner said private investors could take losses if the assets fall in price. He said an auction would determine the price paid for the assets.

"Unfortunately, we will not know until we see the program in actual operation," said Douglas Elliott, an expert on the bank crisis at the Brookings Institution, a middle-of-the-road think tank. "There are substantial reasons to be concerned that the program will fizzle or prove to be too expensive for the taxpayer, but there are also some grounds for hope."

One key stumbling block is that the assets could already have lost 70% of their value, Elliot said. Jeremy Siegel, a professor at the Wharton School of Business, said the plan would prove attractive to private investors because it was like a "call-option" on the toxic assets.
"If the asset values go below the purchase price, the Treasury is going to eat that loss. This plan is definitely going to work," Siegel said in a television interview.

The Treasury's ambitious program would revolve around five steps:
  • A bank decides what pool of assets they would like to sell.
  • After determining that it would be willing to leverage the pool, the FDIC will conduct an auction. For instance, mortgages with $100 face value would be bought for $84.
    Of the $84, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
  • The Treasury would then provide 50% of the equity financing. In this example, Treasury would invest $6 and the private investor would contribute the other $6.
  • The private investor would manage the servicing of the asset pool using managers approved by the FDIC.

Wednesday, 18 March 2009

Misguided economic theories caused the crisis..

The global financial and economic crisis is causing a lot of hardship among ordinary people. How did we get into this mess, while our financial systems were run and regulated by supposedly very smart people?

Robert Shiller, professor of economics at Yale University, shared his ideas in a recent article appearing in the Financial Times. He argued that we underestimated the role of animal spirits (greed, fear, and overconfidence in our ability to predict) in directing our policies and that governments indeed have a very important balancing role to play to make capitalism stable:

We are seeing, in this financial crisis, a rebirth of Keynesian economics. We are talking again of his 1936 book The General Theory of Employment, Interest and Money, which was written during the Great Depression. This era, like the present, saw many calls to end capitalism as we know it. The 1930s have been called the heyday of communism in western countries. Keynes's middle way would avoid the unemployment and the panics and manias of capitalism. But it would also avoid the economic and political controls of communism. The General Theory became the most important economics book of the 20th century because of its sensible balanced message.

In times of high unemployment, creditworthy governments should expand demand by deficit spending. Then, in times of low unemployment, governments should pay down the resultant debt. With that seemingly minor change in procedures, a capitalist system can be stable. There is no need for radical surgery on capitalism.

The General Theory also had a deeper, more fundamental message about how capitalism worked, if only briefly spelled out. It explained why capitalist economies, left to their own devices, without the balancing of governments, were essentially unstable. And it explained why, for capitalist economies to work well, the government should serve as a counterbalance.
The key to this insight was the role Keynes gave to people's psychological motivations. These are usually ignored by macroeconomists. Keynes called them animal spirits, and he thought they were especially important in determining people's willingness to take risks. Businessmen's calculations, he said, were precarious: "Our basis of knowledge for estimating the yield 10 years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing." Despite this, people somehow make decisions and act. This "can only be taken as a result of animal spirits". There is "a spontaneous urge to action".
There are times when people are especially adventuresome - indeed, too much so. Their adventures are supported in these times by a blithe faith in the future, and trust in economic institutions. These are the upswing of the business cycle. But then the animal spirits also veer in the other direction, and then people are too wary.

Social psychologists, notably Roger Schank and Robert Abelson, have shown how much stories and storytelling, especially human-interest stories, motivate much of human behaviour. These stories can count for much more than abstract calculation. People's economic moods are largely based on the stories that people tell themselves and tell each other that are related to the economy.
We have seen these stories come and go in rapid succession in recent years. We first had the dotcom bubble and the envy-producing stories of young millionaires. It burst in 2000, but was soon replaced with another bubble, involving smart "flippers" of properties.
This mania was the product not only of a story about people but also a story about how the economy worked. It was part of a story that all investments in securitised mortgages were safe because those smart people were buying them. Those enviable people who are buying these assets must be checking on them, therefore we do not need to. We need only run alongside them.
What allowed this mania and these stories to persist as long as they did? To a remarkable extent we have got into the current economic and financial crisis because of a wrong economic theory - an economic theory that itself denied the role of the animal spirits in getting us into manias and panics.
According to the standard "classical" theory, which goes back to Adam Smith with his Wealth of Nations in 1776, the economy is essentially stable. If people rationally pursue their own economic interests in free markets they will exhaust all mutually beneficial opportunities to produce goods and exchange with one another. Such exhaustion of opportunities for mutually beneficial trade results in full employment.
Classical theory also tells us that financial markets will also be stable. People will only make trades that they consider to benefit themselves. When entering financial markets - buying stocks or bonds or taking out a mortgage or even very complex securities - they will do due diligence in seeing that what they are buying is worth what they or paying, or what they are selling.
What this theory neglects is that there are times when people are too trusting. And it also fails to take into account that if it can do so profitably, capitalism will produce not only what people really want, but also what they think they want. It can produce the medicine people want to cure their ills. That is what people really want. But if it can do so profitably, it will also produce what people mistakenly want.
It will produce snake oil. Not only that: it may also produce the want for the snake oil itself. That is a downside to capitalism. Standard economic theory failed to take into account that buyers and sellers of assets might not be taking due diligence, and the marketplace was not selling them insurance against risk in the complex securities that they were buying, but was, instead, selling them the financial equivalent of snake oil.
There is a broader moral to all this - about the nature of capitalism. On the one hand, we want to take advantage of the wisdom of Adam Smith. For the most part, the products produced by capitalism are what we really want, produced at a price that we are willing and able to pay. On the other hand, when confidence is high, and since financial assets are hard to evaluate by those who are buying them, people will and do buy snake oil. And when that is discovered, as it invariably must be, the confidence disappears and the economy goes sour.
It is the role of the government at two levels to see that these events do not occur. First, it has a duty to regulate asset markets so that people are not falsely lured into buying snake-oil assets. Such standards for our financial assets make as much common sense as the standards for the food we eat, or the purchase medicine we get from the pharmacy. But we do not want to throw out the good parts of capitalism with the bad. To take advantage of the good parts of capitalism, when fluctuations occur it is the role of the government to see that those who can and want to produce what others want to buy can do so. It is the role of the government, through its counterbalancing fiscal and monetary policy, to maintain full employment.
The principles behind such an economy are not the principles behind a socialist economy. The government insofar as possible is only creating the macroeconomic conditions that will allow the economy to function well.
That is the role of government. Its role is to ensure a "wise laisser faire ". This is not the free-for-all capitalism that has been recommended by the current economic theory, and seems to have been accepted as gospel by economic planners, and also many economists, since the Thatcher and Reagan governments. But it also is a significant middle way between those who see the economic disasters and unemployment of unfettered capitalism, on the one hand, and those who believe that the government should play no role at all.
The idea that unfettered, unregulated capitalism would invariably produce the good outcomes was a wrong economic theory regarding how capitalist societies behave and what causes their crises. That wrong economic theory fails to take account of how the animal spirits affect economic behaviour. It fails to take into account the roles of confidence, stories and snake oil in economic fluctuation.

How do we know?

"Stocks for the long run" is probably one of the most popular standard responses by any money manager and advisor, especially if the strategy is not working very well now. If you are cynical about such responses, don't feel bad, you have the right to be less optimistic than the money manager selling his fund to you. Simply, how does anyone know what the future holds? How do we know the trend lines of the past will be repeated again?

Peter Bernstein, famed author of many books on economics and finance, wrote the following excellent piece that appeared in the Financial Times:

The “long run” used to be one of the most popular topics among investors, particularly institutional investors. In recent months, discussion of the long run has disappeared from view.
The cold statistics have hardly been encouraging for the traditional view. On a total return basis, the Ibbotson data show that the S&P 500 has underperformed long-term Treasury bonds for the last five-year, 10-year, and 25-year periods, and by substantial amounts. These data are not to be taken lightly.

If the long-run expected return on bonds in the future were higher than the expected return on equities, the capitalist system would grind to a halt, because the reward system would be completely out of whack with the risks involved. After all, from the end of 1949 to the end of 2000, the S&P 500 provided a total annual return of 13.1 per cent, while long Treasuries could grind out only 5.8 per cent a year.

But does this history really tell us anything about what lies ahead? Neither the awesome historical track record of equities nor the theoretical case is a promise of a realised equity risk premium. John Maynard Keynes, in an immortal observation about the future, expressed the matter in simple but obvious terms: “We simply do not know.”
Relying on the long run for investment decisions is essentially relying on trend lines. But how certain can we be that trends are destiny? Trends bend. Trends break. Today, in fact, we have no idea where any trend lines might begin or end, or even whether any trend lines still exist.

As Lord Keynes in one of his best known (and wisest) observations, reminded us: “The long run is a misleading guide to current affairs. Economists set themselves too easy, too useless a task if in the tempestuous seasons they only tell us that when the storm is past the ocean will be flat.” To Lord Keynes, the tempestuous seas are the norm. We cannot escape the short run.

There is an even deeper reason to reject the long run as a guide to future investment policy. The long-run results we can discern in the data of stock market history are not a random set of numbers: each event was the result of a preceding event rather than an independent observation. This is a statement of the highest importance. Any starting conditions we select in the historical data cannot replicate the starting conditions at any other moment because the preceding events in the two cases are never identical. There is no predestined rate of return. There is only an expected return that may not be realised.
Recent experience raises a different but perhaps an even more serious question relating to the long run. How do you frame a view of the long run from early 2009? The world has a ruptured financial system showing only fragile signs of recovery. The economic recession now encompasses the whole world. The speed of economic decline is without precedent. Government intervention is also without precedent, in its magnitude, depth, and complexity. Fiscal deficits are reaching numbers no one dreamed about even 12 months ago, yet they will have to be financed.
What kind of a long run is this mess going to produce? Was Bill Gross correct when he wrote for the December 2008 issue of Pimco’s Investment Outlook that “capitalism is and will remain a going concern, that risk-taking – over the long run – will be rewarded, but only from a starting price that correctly anticipates the economy’s growth and its share of after-tax corporate profits within it?”
Can capitalism remain “a going concern” after an extended period characterised by massive government intervention into the economy – and bail-outs of firms that would otherwise have failed? To what extent will the “going” in Mr Gross’s vision be tied to government intervention in these forms and magnitude? Or is Mr Gross’s optimism justified? Will we be able to unwind the role of government in the capitalist system as we know it and go back to the status quo ante?
Will our economy and society emerge so risk-averse after these experiences that years will have to pass before we return to a system naturally generating vibrant economic growth and a renewed willingness to both borrow and lend? Or will we head in the opposite direction, where faith in ultimate bail-outs will justify the wildest kind of risk-taking? Or will the entire structure collapse from government debts and deficits that turn out to be so unmanageable that chaos is the ultimate result?

We can neither answer those questions nor can we claim they are a complete list of the possibilities. The unknown today seems more than usually unknown. Then my whole point remains the same. The long run is an impenetrable mystery. It always has been.
Quoted from: "Insight: Flight of the long run" by Peter L. Bernstein, Financial Times, FT.com, February 25, 2009.

Friday, 13 March 2009

Understanding the global financial crisis 101

Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around and as a result increasing numbers of customers flood into Heidi's bar. Taking advantage of her customers' freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most-consumed beverages. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these customer debts as valuable future assets and increases Heidi's borrowing limit. He sees no reason for undue concern since he has the debts of the alcoholics as collateral.

At the bank's corporate headquarters, expert bankers transform these customer assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are then traded on markets worldwide. No one really understands what these abbreviations mean and how the securities are guaranteed.

Nevertheless, as their prices continuously climb, the securities become top-selling items. One day, although the prices are still climbing, a risk manager (subsequently of course fired due to his negativity) of the bank decides that slowly the time has come to demand payment of the debts incurred by the drinkers at Heidi's bar.
However they cannot pay back the debts. Heidi cannot fulfill her loan obligations and claims bankruptcy. DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %.

The suppliers of Heidi's bar, having granted her generous payment due dates and having invested in the securities are faced with a new situation. Her wine supplier claims bankruptcy, her beer supplier is taken over by a competitor. The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties. The funds required for this purpose are obtained by a tax levied against the non-drinkers.
Now that explains the financial crisis...

Madoff's Legacy

What effect will Bernard Madoff's high-profiled criminal offences have on investors' confidence?
Kate Gibson, MarketWatch reporter, wrote the following story:
"Everybody knew about the bucket banks, the boiler rooms, everything you saw in the movie 'Wall Street.' But this guy [Madoff] was chairman of Nasdaq. It's like reading history and finding out that George Washington was actually Benedict Arnold's contact in a huge spy ring," said Doug Roberts, chief investment strategist at ChannelCapitalResearch.com.

The issue extends beyond Madoff, given other recent cases that while smaller, give the same impression of regulators asleep at the wheel, said Roberts. He pointed to Allen Stanford, the Texas tycoon whose alleged fraud was shut down in late February by the Securities and Exchange Commission, and Arthur Nadel, the Florida fund manager who allegedly lost millions of investors' dollars.

"It's a colossal failure for the Securities and Exchange Commission when you can have a scheme of 20-plus years go undetected, even after the agency has investigated several times," said Karl Buch, a former assistant U.S. attorney now at law firm Chadbourne & Park.

Madoff on Thursday pleaded guilty to charges he stole billions of dollars from investors around the world, starting a huge Ponzi scheme in the early 1990s.
Others said major damage was already done.
"This man has single-handedly put the nail in the coffin for millions of baby boomer investors with respect to their desire to invest in the stock market. Billions of dollars have been lost and untold billions more have been pulled from equities, never to return," said Dan Greenhaus, an analyst at Miller Tabak & Co.

The "sheer size" of Madoff's Ponzi scheme got the media's attention, but was probably less of a focus for the average retail investor, who is likely more concerned about job security in the current economic climate, said Mike Zarembski, senior commodity analyst at brokerage optionsXpress Inc.

But the Madoff case does underline the case for diversified holdings.
"You don't get strictly bull markets. That's why asset allocation is very important," said Zarembski.
Greenhaus, however, believes the market's decline and factors such as Madoff is translating into a scenario where the 60-plus crowd is now done with equities, along with a large majority of those 50 and older.
"These people are going to hang on with a certain portion of their investments in order to have a shot at recouping some losses, but once they reach a point at which they are satiated, they will remove the remaining funds, finding fixed income very much to their liking after eight years of absolutely terrible equity performance," he said.

"This should prove to be a major headwind for equities going forward, as this segment of the investing population controls a tremendous amount of wealth," said Greenhaus.

Monday, 2 March 2009

Hitting multi-decade lows...

Surely, we are seeing a an economic meltdown of note. Anyone that may have thought this is a typical V-shape recession will have to reconsider. The stock markets have been telling us that for months anyway, now the latest economical statistics coming out of the USA are confirming.

Rex Nutting of MarketWatch reports:

The U.S. economy was hitting on virtually no cylinders in the fourth quarter, as gross domestic product fell at the fastest pace since 1982 on sharp declines in consumer spending, investment and exports, the government said Friday.

GDP fell at a 6.2% seasonally adjusted annualized pace in the final three months of 2008, revised from the initial estimate of a 3.8% drop, the Commerce Department reported. It was the worst decline in GDP since a 6.4% decrease in the first quarter of 1982.

"Economic developments in recent months have been consistently worse than the worst-case scenarios," noted Stephen Stanley, chief economist for RBS Greenwich Capital.

Economists surveyed by MarketWatch had expected a revision to a 5.5% decline, based on updated monthly data on inventories, exports and other key measures. The revision showed inventory investment and exports "substantially weaker" than first reported, the government said. Consumer spending was also revised lower.

Final sales of domestic product fell 6.4%, the worst since 1980. Final sales to domestic purchasers, a measure of domestic demand, fell 5.7%, also the worst since 1980.

Unadjusted for price changes, GDP fell 5.8% to an annual rate of $14.2 trillion in current dollar terms, the data showed.

The recession that began in December 2007 intensified in the fourth quarter following the government rescue of several large financial institutions and the collapse of Lehman Bros. The ensuing credit squeeze has driven consumer and business confidence to generational lows, and cost nearly 2 million Americans their jobs.

Economists don't expect any relief in the current quarter, which ends March 31. The current projection sees first-quarter GDP falling at a 4.8% annual rate. Since 1947, GDP has never fallen by more than 4% for two quarters in a row.

Most economists don't expect GDP to grow until the second half of the year, when the leading edge of the $787 billion fiscal-stimulus plan begins to have an impact.

"We are in the midst of the worst recession in the post-war period, even factoring in the massive stimulus program," wrote Nariman Behravesh, chief economist for IHS Global Insight.
Federal Reserve Chairman Ben Bernanke said earlier in the week that he was confident the economy would rebound modestly later this year and into 2010, but only if the government's efforts to stabilize the banking system prove successful.
Just as the GDP report was released, the Treasury Department reached an agreement to bolster Citigroup Inc.'s balance sheet by converting earlier taxpayer investments into common equity shares.

There were a few bright spots in the GDP report. Prices fell at the fastest pace on record, helping consumer and businesses' purchasing power. The personal consumption expenditure price index fell an annualized 5%, a record, while core prices rose just 0.8%. Real disposable incomes increased at a 3.4% pace. Another bright spot was the government sector, which added 0.3 percentage point to GDP growth.
But most of the report could only be described as ugly. Consumer spending fell at a 4.3% pace, the worst since 1980, and subtracted 3 percentage points from growth in the quarter.
Spending on durable goods plunged 22.1%, the worst since 1987, while spending on nondurable goods fell a record 9.2%. Spending on services rose, up 1.4%.

Meanwhile, business investment dropped 21.1%, the worst since the 1975 recession. Investments in equipment and software fell an eye-popping 28.8%, the worst since the 1958 recession. Spending on structures fell 5.9%, the first decline in more than three years. Business investment subtracted 2.5 percentage points from growth.
Residential investment fell 22.2%, the 12th consecutive decline in the sector where all the trouble began. Housing investments subtracted 0.8 of a percentage point from growth.

Export growth had kept GDP positive during the first two quarters of the recession early last year, but global growth has now collapsed, kicking away the main source of support for the U.S. economy and its workers.

Exports fell 23.6% in the fourth quarter, the most since 1971, reflecting the global recession that is hitting Europe, Japan and other trading partners even harder than the United States. Exports of goods dropped 33.6%, also the worst since 1971. Imports fell 16%, the most since 1980, as U.S. consumers and businesses just stopped spending. Exports subtracted 3.4 percentage points from growth, while the decline in imports added 3 percentage points.

Inventory building added 0.2 of a percentage point to growth. Higher inventories should be considered a negative for future growth, as firms will have to reduce production while they work down their stocks to meet demand. However, inventories built up much less than first reported a month ago.

For all of 2008, GDP increased 1.1% despite the economy being in a recession for the entire year. Growth was boosted 1.4 percentage points by the improvement in the trade balance. Government spending contributed 0.6 of a percentage point to growth, with consumer spending and business investments each adding 0.2 of a point. But, on the downside, residential investments subtracted 0.9 of a percentage point in 2008, and inventories subtracted 0.2 of a point.

Which way to invest: Hedge funds, actively-managed funds or index funds?

Basically an investor has three investment choices: invest in a actively managed fund (for most investors the typical or conventional choice), or an index fund that passively tracks a specific market benchmark and a hedge fund that may use a host of conventional and unconventional strategies.
Recent studies have shown that low-cost index funds indeed make a lot of sense. Mark Hulbert, editor of The Hulbert Financial Digest reports:

THERE’S yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

Basic stock market index funds generally aspire to nothing more than matching the returns of a market benchmark. So in a miserable year for stocks,
index funds may not look very appealing. But it turns out that, after fees and taxes, it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.

That, at least, is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. Kritzman
set up his study to accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees.

It is surprisingly hard to measure these costs accurately. The bite taken out by taxes, for example, depends on the specific combination of positive years and losing ones, as well as the order in which they occur. That combination and order also affect the performance fees charged by hedge funds.

Kritzman devised an elaborate method to take such contingencies into account. Then he calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments
: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages.

Kritzman found that, net of all expenses, the winner was the index fund. The index fund’s average after-expense return was 8.5 percent a year, versus 8 percent for the actively managed fund and 7.7 percent for the hedge fund.

Expenses were the culprit. For both the actively managed fund and the hedge fund, those expenses more than ate up the large amounts — 3.5 and 9 percentage points a year, respectively — by which they beat the index fund before expenses.

If such outperformance isn’t enough to overcome the drag of expenses, what would do the trick? Kritzman calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.
The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland.
Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.

But even that sobering statistic paints too rosy a picture, the professor said. That’s because it’s one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. Indeed, he said, he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well.

Professor Wermers said he believed that it was “exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone.”

“By definition, therefore, such a fund could not have been identified in advance,” he added.
The investment implication is clear, according to Mr. Kritzman. “It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And he said that those who still insist on an actively managed fund are almost certainly “deluding themselves.”

What if you’re investing in a tax-sheltered account
? In that case, Mr. Kritzman conceded, the odds are relatively more favorable for active management, because, in his simulations, taxes accounted for about two-thirds of the expenses of the actively managed mutual fund and nearly half of the hedge fund’s. But he emphasized the word “relatively.”
"Even in a tax-sheltered account,” he said, “the odds of beating the index fund are still quite poor.”