I am currently reading a book about the history of hedge funds, which I will discuss in greater detail in the near future. One of the very interesting things that I’ve read is how funds that initially start being neutral have temptations to change that over time. What do I mean by “neutral”? There are many different ways this is used but the most used interpretation is when a fund owns and shorts an equal amount of dollars.

When we do long and short trades, we do exactly that as in a trade such as our only live one, Long Google and Short eBay, we will be buying $2500 worth of Google (GOOG) stock and selling the same amount of value of eBay (EBAY) shares. The objective of course is for market movements to have no impact on the trade as a 2% gain on all stocks would result in no gain or loss.

One would certainly argue that from the moment the trades goes live, it is no longer “neutral”. Why? Because if the price of Google increases by 1% while eBay’s doesn’t, the $2500 would now be worth $2750 and the fund would be “net long” $250. That is one reason why funds are rarely “100% neutral”. As of writing this, that trade is slightly up giving me a small “positive exposure”.

Another interpretation of being neutral is looking at the beta which we took a in-depth look into earlier this. Why? Some stocks such as Baidu are much more volatile than others like Exxon so being long on one and short the other would not necessarily make a fund “immune” to big market movements.

The End Goal For Me Remains To Be Market Neutral

While I do not want to be constantly rebalancing my trades, I do start them all as neutral trades which gives me a very small exposure in terms of dollars and even from a beta perspective. The impact is that my returns should be judged on an “absolute basis” rather than compared to market returns. In many ways, it is good because it provides additional diversification from more standard portfolios or even from dividend investing. Absolute returns means that every year, my trading objective could be a 7-8% gain with the hopes of having some exceptional years (such as 2011, with a 90% return so far) and limit losing ones. That compares with “long only” funds that will try to do a bit better than the indexes every year. Even beating the market by 1% can often be seen as a success, no matter i the market returns 20% or -20%.

Temptation Arrives

In the past few years, markets have been very volatile but the overall result has been fairly steady which has been neutral from my perspective. However, think about a market where indexes rise 20% per year for 3 or 4 straight years? My 7% would still be good considering my fund but I would be underperfoming “long funds” severely and there would certainly be a temptation to shift my trading towards being “long”. How? For example by being long $2500 and short $2000 for example.

Once that is done, I would probably be tempted to increase that amount event more and in the end might not be doing as much of the “shorting” part. That is precisely what has happened to a number of large hedge funds over the decades as they changed their trading styles to better profit from trending profits but did not reverse in time to avoid the inevitable market correction. The opposite would also be possible as a fund that has great success in shorting stocks during a market crash could slowly “abandon” the long parts of the trades.

Please Call Me Out

If ever you see trades, commentary or anything else here or on our free newsletters that seems to indicate that my technology trading is shifting and that I’m falling to the “temptation”, please call me out, I would certainly appreciate it.

Please Tell Me

Have any of you suffered temptations to change your trading or investing “style”? What caused it? Market trends? Personal events? Anything else?

One very interesting and surprising fact is that despite the fact that dividend investing is bigger than it has probably ever been US companies continue to avoid paying out earnings as much as they should. If shareholders want to get higher dividend amounts, why aren’t public companies answering those needs? The biggest reason is that US companies are hoarding cash a lot more. The portion of their earnings that is paid back to shareholders through dividends has been decreasing for years now.

Why Companies Are Keeping Their Cash

For some such as Apple, the two main reasons have been:

-Willingness to keep large amounts of money to have more M&A/R&D options
-Refusal to give its shareholders and employees the impression that growth will slow down (common perception about dividend paying companies)

For many others however, the main problem is that much of their huge cash reserves are stuck overseas. A company such as Google has a corporate structure that minimizes is every way possible the amount of taxable income in the US. That means most of its revenues are cleverly “credited” to its overseas operations. That means bringing back those huge cash reserves right now for a company like Google would result in important payable taxes which is something they want to avoid.

How To Fix This Issue

There are few easy ways out of this issue. Many large companies like Google are asking for a one time exemption (as has been done in the past) for them to bring back the cash with a “tax holiday”. That could of course be done as a quick fix but it does not resolve the underlying problem. As long as big corporations “earn” most of their cash abroad, it will be difficult for them to pay out as much as they and should pay out to shareholders. What must be done for corporations to earn more of their revenues in the US? Probably two main things; Diminishing the corporate tax rate and eliminating loopholes. That would not solve all cases, far from it in fact. But it would be enough to ensure that a bigger share of earnings would be earned and taxes in the US.

In The Meantime…

There are many different ways to improve your chances of getting bigger dividends and strong dividend growth. One such way is of course to look abroad which is exactly what we did when discussing investing in China. However, I thought it would be interesting to take a quick look around the globe to see dividend yields and how things are looking up for dividend investors:

It could be tempting to look at France and Spain as great dividend plays but the reason their dividend looks attractive is very simple; their financial institutions are in big trouble and could suffer severe losses which will in the end result in big dividend reductions.

However, an index such as Brazil certainly looks very attractive and its resource-based economy could suffer if the world economy drops back in recession, I think the dividend is fairly safe. How would you buy Brazil? The most obvious way would be to buy an ETF, the main one being EWZ which yields..3.69%! Not very far from its target index right?

Yesterday, we took a deeper look at China and why I think it needs to be a significant part of your retirement holdings. While the value of those assets will fluctuate a great deal, I think there’s little doubt that over 20 or 30 years, you will be much better off than if you decide to stick to already developed economies. I can see how some would argue for more diversification among emerging economics (BRIC and others) and I do understand that but I still think that there are significant advantages to being the world’s most important economy which is exactly what China will become in the near future.

Once someone decides to invest in China, the big question becomes what type of investment should be made. First, we can take a look at the biggest names on the Hong Kong exchange (where most large Chinese corps have generally gone in the markets)

I think it’s easy to start off by excluding direct trading in China. Not only are there complications with trading in the Chinese currency but there are also a number of legal issues to deal with that make it only worthwhile for large institutions to be active. That leaves a few different options:

-Buying ADR’s on US markets: Here is the list of the largest ones:

You can certainly get exposure to some of the bigger names such as Baidu (BIDU) that trade on US markets which also gives some level of assurance that the financial statements by these companies are legitimate. I think the main issue when doing this is to get exposure to the right names, as many large Chinese corporations are not listed in the US.

-Buying Pink Sheets: We had discussed pink sheets trading and it can certainly be a viable option but I think that becomes rather risky for many Chinese corporations. There have been so many scandals and frauds in the listed stocks such as Sino-Forest that buying companies that operate under even less restrictions becomes very risky. How in the world would you verify what you are actually buying.

-Buying ETF’s: Personally, I think getting exposure through ETF’s is by far the best way to get long term exposure to China’s stock market. Not only are the costs more reasonable but you have a manager that is paid to do do stock selection and has access to the best companies no matter where they are traded. Here is a list of US traded China ETF’s:

Personally, as unoriginal as it may seem, I think FXI is a great play. Why? Because it’s difficult to know which Chinese companies will dominate 10 or 20 years from now but I think it’s easy to imagine that going with the biggest ones is a good bet. Over time, the index will add “emerging ones” and as China becomes a global leader, it is likely to promote national champion companies as it has done with Baidu (BIDU) in the internet giving the company a very favorable environment against competitors such as Google (GOOG). So personally, I think FXI should be a significant holding in any very long term portfolio, do you agree?

China has clearly been a very volatile market in the past few years and very often, that has been marked by important declines. That is bound to happen over and over in China but I would still argue that China should be a significant portion of your holdings if you have a long term horizon. My main point would certainly not be that it will be a smooth ride but rather that it is almost certain that over 30 years or so, the Chinese market will rise more quickly than US and other markets If that is the case, wouldn’t you want to have at least 25% of your holdings in China?

Am I crazy to think that even holding 30-40% of my assets in China could be a great decision?

I’ve written about my convictions regarding Chinese internet stocks but I think that Chinese stocks will also tend to overperform significantly over the next couple of decades.What makes me think that?

-Economy will grow rapidly: You might know that stock markets do not track the economy, especially in the short to medium term. However, as the Chinese economy overtakes the US and becomes the focus point of the world economy. I agree that on a GDP per capita basis, China will still remain well behind most industralized nations but in a nation of 1.3 billion people, the best performing companies are certain to do well. A company such as Baidu has the potential to be at the center of ecommerce in China, and many more leaders will emerge over the next few years. I would argue that the explosion of the economy will lead to incredible profits for the market leaders in dozens of different markets. Those are the companies that you want to own.

-No debt: China and other emerging economies have one big difference with other leading economies, they have basically no debt which in a world where Europe and the US are becoming increasingly fragile. China will have incredible opportunities to buy valuable assets from desperate nations in Europe and abroad. I think it will also help China invest at home to help those companies that will be able to create jobs.

-Attractive Valuations: Because of the fact that few investors currently hold Chinese assets and that the risk (especially for those investing with a shorter time frame) is more important, the valuations are much more attractive. For example, the forward P/E of Chinese stocks is below 10 while US markets continue to trade at a 13 forward P/E or so. Over time, as China becomes more established, that difference will narrow and the earnings of Chinese companies will no doubt increase much faster than US ones.

-Solid dividend yields: While US companies have generally been decreasing the portion of their earnings that they pay out, companies in emerging markets continue to pay out high dividend payouts making them very attractive for dividend investors. If you compare at FXI for example, which invests in the 25 largest Chinese companies to the Dow Jones Industrial average (30 blue chip US companies) you will see:

FXI: 3.88%
DIA: 1.87%

That is a staggering difference and the difference is comparable if you take broader indexes. I’ve talked many times about the benefits of international diversification and clearly China would be near the top of the list of places that dividend investors should look for.

-Less exposure to European banks: If you have been following the news lately, you will remember that many of the largest banks in the world have been very volatile because of their direct and indirect exposures to sovereign bonds. Take the example of Morgan Stanley which does not hold huge positions in Greek bonds but it has large interests in French banks that do have those exposures. That has caused Morgan Stanley to be highly volatile. Emerging countries banks and China in particular tend to have much smaller exposures to the type of issues that the world economy is currently facing.

-Strong currency: The Chinese Yuan continues to be under the radar in terms of world trade although it is quickly gaining importance. The US government has made it crystal clear that it thinks the Yuan is massively undervalued but the Chinese government is looking to let its currency appreciate only very slowly over the years so that it can adapt to a stronger currency. That will have a very big impact on all Chinese assets that will also benefit from this appreciation. Add to that the fact that the Yuan is likely to slowly become a second “reserve currency” which will also add tremendous pressure upwards and I can only imagine how much more the Chinese Yuan will be worth 10 or 20 years from now.

Tomorrow, I’ll take a look at different ways to invest in China