Sunday, November 22, 2009

Note to Stock Pickers: Study Bonds and Bond Markets - Alpha

In this issue:
1) The Achilles Heel of Stock Pickers
2) Bond Basics are Related to Stock Basics
3) Bond Market Indicators
4) Tea-Leaf Reading in Bond Markets
5) Get Rich or Die Tryin’

Dear Friends, Colleagues, and Investors:

Having learned to invest in the bull markets of the 1990s and 2000s, I often saw the world of capital markets as an equity investor buying stocks. Now I realize it’s important to step back and see the bigger picture, both to be a better stock picker and an all-around better total return investor (who can hold bonds, cash, ETFs, REITs, and other securities as needed). My hypothesis is that stock pickers would be much better at what they do if they study bonds and bond markets.

Please see the attached pdf file for this newsletter, here:


Thursday, November 12, 2009

In Support of the Tobin Tax - Ari Paul

Dear Friends, Colleagues, and Investors,

A "Tobin Tax" was originally designed to be a tax on foreign currency transactions with the goal of reducing short-term speculation. The economist James Tobin suggested that a tax of about 0.25% be levied on all foreign currency transactions; the income earned from the tax would be incidental; the greater effect would be to dampen speculative money flows that wreck havoc on economies. There is now widespread talk of applying a Tobin tax to all financial transactions.

The most obvious effect of the Tobin Tax would be to shrink the financial sector. As a professional trader at a large market-making firm, a Tobin tax would likely be devastating to my career, so my writing this week may surprise you. In this newsletter I'll lay out a vigorous case for why the Tobin tax should be implemented. The objections to the Tobin tax are more obvious than its benefits so I'll present the case in a question and answer format.

1) Will a Tobin Tax Increase Unemployment?

If the financial sector shrinks, won't a lot more financial professionals will be out of work?

By definition, investors as a whole will perform exactly as well as the market (minus transaction costs). If everyone expends a lot of time and energy to beat the market, as a group, they are wasting valuable resources. Now, a little bit of competition is healthy as investors research companies and help push asset prices where they should be. However, many of the smartest engineers and business minds now devote themselves purely to outwitting one another in completely useless ways. There are some twenty hedge funds filled with programmers and engineers trying to figure out how to send orders to stock exchanges a millisecond faster than one another. The fastest will make billions of dollars in profits. Yet reducing latency from 200 milliseconds to 190 milliseconds provides absolutely no value to society, or even to the market as a whole. These hedge funds soak up large amounts of the intellectual capital of the country. For the last few years about 30% of Harvard's MBA graduates have been heading to Wall Street jobs. These are the business leaders who could be entrepreneurs inventing new services or managers finding ways to increase labor productivity. Instead, they're "playing poker" (e.g. pursuing technical analysis, algorithmic trading, and low latency trading) with astrophysicists and electrical engineers who have also been enticed by the higher pay of Wall Street. It's impossible to estimate the cost to society of having these otherwise productive people spend their time siphoning money off the general public.

Depending on the scale of the Tobin Tax, it could well put 30% of all financial professionals out of business. That's a good thing. We want our electrical engineers working on cheaper energy, not trying to send stock orders a millisecond faster than engineers at another hedge fund.

2) Will a Tobin Tax Make the Market Less Efficient?

The "efficient market hypothesis" suggests that the more speculators are involved in a market, the more "efficient" the market will be. These speculators might push the value of stocks and other assets to "fair" value which helps the capital markets run smoothly. For example, by pushing the stock price of a good company higher, speculators let that company raise capital to expand. By lowering the stock price of an insolvent company, speculators signal to the company's creditors and suppliers that the company is in trouble. This is great in theory, except it doesn't actually happen.

When transaction costs are very high, only a handful of market participants can earn significant profits. The less skillful investors/traders go out of business quickly, because not only do they need to beat their competitors, they also need to overcome the higher costs of business. So with high transaction costs, the main market movers are the very best investors/traders. As the transaction costs are lowered, less and less skilled gamblers are enticed to play, and these gamblers do what you'd expect - they push prices in stupid ways. It's these less skilled gamblers that produced the tech bubble in the late nineties and the real estate bubble we're still dealing with. Lower transaction costs act similarly to easy credit - they encourage gambling. Gambling makes the market less efficient as the gamblers are more likely to act as a herd and send prices far from fair. So a Tobin Tax might make the markets more efficient. While this isn't clear, I judge it unlikely that a Tobin tax will make the markets any less efficient.

3) Will a Tobin Tax Drive Up Transaction Costs?

The more speculators are involved in a market, the more liquidity the market will have. The idea is that the speculators reduce the bid/ask spreads and therefore reduce the transaction costs to all involved. For example, today you can buy Microsoft stock for $28.51 and sell it at $28.50. This suggests that the fair value is $28.505, so the theoretical cost to execute the transaction is just half a penny. If there weren't so many speculators constantly willing to bet on Microsoft's stock, you might have to pay $28.61 to buy the stock and you'd only be able to sell it at $28.40. The fair value is still $28.505 but now you're paying more than a dime to execute the trade. Wouldn't the Tobin tax drive up transaction costs and therefore be a burden on all of society?

A Tobin tax would certainly raise transaction costs, but this isn't necessarily a bad thing. For example, we deliberately make cigarettes more expensive with a tax to discourage people from smoking. In this analogy, the effect of speculation on society is similar to that of smoking. It's true that anyone buying or selling Microsoft stock would effectively pay more to do so, but for investors, the cost is negligible. Warren Buffett deliberately kept the bid/ask spread of Berkshire Hathaway wide to discourage speculation. Most people lose money trading stocks. In fact, more than 70% of professional mutual fund managers underperform the indexes they try to track. In other words, the more you play the stock market game, the more you're likely to lose. Yet, many retail investors believe they can consistently beat the stock market and are convinced to gamble and try. They're lured by "low commissions" on stock trades and they're lured by small bid/ask spreads. The low transaction costs make it seem inexpensive to gamble. The low costs make it seem like they have a great chance of wining. With higher transaction costs, many of these hopeless gamblers would be dissuaded from gambling in the first place. Not only does stock market gambling cost the general public great amounts of money, it produces a deadweight loss to society. Where does the lost money go? It goes to professional traders who only exist because the public keeps losing money. If the public stopped gambling on stocks, the traders (who are generally bright and well educated) would find gainful employment producing something of value to society. The higher transaction costs from a Tobin Tax would keep more money in the public's pockets.

4) Isn't a Tobin Tax a "tax", and aren't taxes bad?

Whatever money the Tobin tax raises will be coming out of the already weak financial sector, businesses, and even an individual's 401K. Isn't this bad?

The most obvious "benefit" of the tax - the generation of revenue, is the least important benefit. Taxes aren't inherently a good thing or a bad thing; they redistribute income and depending on how intelligently the government spends the money, that could be productive or destructive. It's also important how the tax is collected. For example, income taxes have been proven to reduce the amount of time people spend working, obviously a destructive side effect. The Tobin Tax is about as productively collected a tax as I can imagine. If managed properly, it would have little impact on the kind of financial transactions that benefit society, but would eliminate a great bulk of the kind of transactions that are harmful. For example, if a company is a great investment, that 0.25% tax wouldn't dissuade any intelligent long-term investor from buying their stock. However, it would completely end stock day trading. The effect on an individual's 401K would be negligible; the vast majority of the tax would initially come from financial speculators, many of whom would quickly leave the industry. The remaining burden of the tax would fall on legitimate hedgers and the remaining profitable speculators.

5) Can We Trust That the Tax Will be Intelligently Applied?

Isn't it likely that big financial firms would find ways to outsmart the regulators and gain legal loopholes or simply escape enforcement? The big firms have ignored other rules like the "uptick rule" for shortselling, or the ban on naked shortselling.

This is a very real and serious criticism. If you believe the federal government is not competent enough to impose meaningful financial regulation, you are justified in opposing a Tobin tax as it could be abused to merely solidify the oligopoly of the major financial players. To implement a uniform Tobin tax, we will probably need the kind of populist anger and political consensus that existed in the great depression and gave rise to the Glass-Steagall Act.

In Summary: A Tobin tax would reallocate smart hardworking people from the "poker game" of trading and wealth management, to more productive enterprises. If applied intelligently, it would reduce speculation, dissuade the public from wasting time and money gambling in the stock market, and have few negative effects. It seems unlikely to gain enough political support to pass, and even if it was passed by all the major financial centers, there would be a real risk that it would not be uniformly applied.

Your Masochistic Trader,
Copyright 2009 Risk Over Reward. All Rights Reserved

Friday, November 6, 2009

The Movable Bullseye - Alpha

In this issue:
1) What is the purpose of investing?
2) Beating Inflation
3) Beating Bonds
4) Beating a Risk Index
5) How to beat the chess grandmaster Bobby Fisher

Dear Friends, Colleagues, and Investors:

We have noticed that many investors, both sophisticated and small, don’t seem to understand the purpose of their investing. “Making money” is too simple an answer, as you can make money and still be worse off. The question is simply, “Why invest?” The answer to this question is philosophical and affects your pocket book in a deep way.

1) What is the purpose of investing?

The purpose of investing is not “making money.” That is the correct answer for investment advisors, as most make money off their clients’ ignorance and carelessness through layers of fat fees. A rational investor should do three things:

i) Preserve the after-inflation value of capital. This means an investor’s capital should buy the same amount, or more, of goods and services after a few years. An example:
-An investor has $100, which can buy 10 bread loaves and 2 massages.
-The $100 is invested and grows to $140 in 5 years.
-In year 5, the $140 can buy 10 bread loaves and 2 massages.
-The investor is on even ground – no losses and no gains. Despite “making money” she is no better off.
Any strategy that loses to inflation but beats its benchmarks, however numerous and glorious the benchmarks are, is bunk. Few equity mutual funds (less than 20%) have beaten their index benchmark in the last 5 and 10 years. Almost none have beaten inflation, which has averaged a little above 3% (no major US equity benchmark has beaten inflation in the last 5 years).

ii) Match or beat the “risk-free” opportunity cost of capital. Any investor can buy a risk-free asset and sleep safely. An opportunity cost is something that an investor forgoes. For example, if you get coffee at Starbucks, your opportunity cost is coffee from home, from Peets Coffee, or from the corner mom-and-pop vendor. More specifically to investing, if you invest in bond A, your opportunity cost is what bond B, C, or D could have given you. Generally, a diversified bond index like the Barclays Capital US Aggregate Bond Index (the “Barclays Agg,” formerly called the Lehman Aggregate) is probably the best marker for a risk-free investment, though on closer analysis this is a tough call. At the very least, investing in the securities market should get you a return better than your bank savings account or CD.

iii) Match or beat the “risk-taking” opportunity cost of capital: An investor that wants to take more risk can buy risk assets. She should measure her progress against three benchmarks: inflation, the risk-free bond benchmark, and a “risk index” that is appropriate to the type of risk she is taking. The most common “balanced” US risk index is a 60/40 blend of the S&P 500 and the Barclays Agg, but the appropriate risk index should be specific to an investor’s goals.

2) Beating Inflation

Beating inflation is a common sense benchmark. It is what sophisticated managers mean, explicitly or implicitly, when they promise “absolute returns.” Any investment strategy offering absolute returns, yet not beating inflation, is stale sugar water.

The more nuanced question here is, “What is inflation – which index should one use?” This is relevant for two reasons. First, investors have a global opportunity set: they can pick the currency of their portfolio and many measures of inflation. Second, official government measures of inflation aren’t that trustworthy.

The conventional wisdom is that investors should use their home country currency and the most commonly used home inflation indicator. For Americans, this would be the US dollar (USD) and the Consumer Price Index for Urban Consumers (CPI-U). Yet as the dollar weakens, smart investors are looking more to a basket of currencies or gold as alternate measures of their portfolio’s worth. Take gold as an example. Suppose your portfolio is worth $100K today (about 100 ounces of gold). Suppose it grows to $150K in 5 years, but that only buys 80 ounces of gold. You are poorer. For simplicity, it’s easy to just use your home currency as the base measure. Yet if your home currency isn’t the Chinese yuan (CNY), which seems undervalued, but rather the USD, you may want to think twice about the base unit.

Suppose you stay with the dollar. Is the CPI-U a good measure of inflation? Perhaps not. For decades, the US government defined CPI-U using a fixed basket of goods. In the 1990s, government officials changed this to include substitution effects and hedonic improvements. Basically, they reasoned that: if beef prices went up, people would substitute cheaper chicken, and so chicken should be weighted more in the basket hence higher beef may lead to lower inflation; if a computer selling for $1000 had much better performance stats, it should be weighted cheaper, hence lowering inflation, though you still paid $1000 your computer. Both these Clinton era changes brought CPI-U inflation way down in the US and UK, while consumers still felt ripped off. For more information on these games with inflation indexes, read what John Williams of ShadowStats writes and David Altig of the Atlanta Fed counters. Governments playing games with currencies and inflation is centuries old; rich countries like Argentina still play the game today. As Williams suggests, the best measure of inflation is intuitively an equal-weighted basket of goods and services, as the CPI-U was previously calculated (what Williams calls his I-7 or his SGS Alternate I-8 inflation measure). But you can’t get the I-8 from the Federal Reserve or the BLS, you need to go to

Finally, investment managers who earn performance-based fees (carry) make off like rogues and bandits when inflation is higher than expected. Few investment funds have a hurdle rate, and often the hurdle is low (4 to 6%). In a world of high inflation, esp. when inflation is above the hurdle rate, all assets go up in price and your investment manager takes a disproportionate cut of your principal while adding no value.

Beating inflation is a no-brainer. So how come so few institutional investors write it in their contracts with managers? Why don’t more managers compare their return to inflation? The dirty secret is that many managers would do quite poorly and so they don’t want to measure their value-add (or value-subtract) by this bulls eye.

3) Beating Bonds

Beating bonds should be the next goal of any investment plan. Today, it’s easy to invest your money in a low-cost, diversified bond index and sleep safely. Bonds give you safety of principal and some idea of an expected return: the SEC yield, yield-to-maturity, and yield-to-worst approximate what you will earn. In the US in the 20th century, short term bonds (1-3 year maturities), beat inflation in almost every 10-year period (if the bonds were held to maturity). Hence investing in bonds is one step above beating inflation; it’s better than getting a smidgen of a nominal return from a savings account or bank CD. Of course an investor can make bad individual bond bets and lose money quickly: she can buy 30-year Treasuries when rates are low (4%) and sell them just as rates peak at a higher lever (12%); or she can buy high yield bonds when spreads and defaults rates are low, right before a business cycle turns negative. Also bond math and bond investing can be quite complicated. Experts can use Taylor series, linear programming, or option pricing models to price bonds. Yet a diversified index of bonds, like Vanguard’s Total Bond Market Index Fund, is a safe and simple place to be most of the time (not before sudden shifts from deflation/low inflation to high inflation, though).

Again there are some nuances. Investors can argue about:
-the best reference bond index should be US-based or Global-cum-US (to take currency exposures into account)?
-what to do before high inflation hits (buying low duration or linker bonds)?
-whether the index include just government bonds or a diversified pool of bonds (government, corporate, agencies, loans, etc.)?
The answers to these questions depend on the sophistication of the investor.

Beating bonds is a goal that most equity or other risk-asset investors do not acknowledge. Today, many absolute return hedge fund managers or long-only equity managers will point to their returns relative to an equities index (the S&P 500, Wilshire 5000, Dow Jones Industrials, etc.). Yet if they underperformed a bond reference index, like the Barclays US Aggregate Bond Index, these equity managers have destroyed your wealth. If you’re not getting a premium from stocks over the safer counterparts of bonds, your managers are fleecing you. And 3, 5, and 7 year returns are the best timeframe to measure this. In any single year, bonds can beat stocks. If bonds beat stocks for more than 3-years, you have a bad manager.

4) Beating a Risk Index
From the discussion above, investing is easy. You save money. You stick your saved money in a diversified bond index, from a trusted provider (Vanguard, Fidelity, Pimco), to “own” the bond market. If the experience of the US bond markets from 1900 to 2009 offers any future guidance, a diversified bond investor can expect a steady return about 2-3% points above inflation.

Yet bond returns may not be enough for investors who want to take more risk and earn higher returns (but keep in mind you can take more risk, bad risk, and earn lower returns!). In about 60% of all ten-year periods from 1900-2009, stocks and other risk assets beat bonds. When evaluating managers of risk-assets, investors should find an appropriate risk-index to measure performance. Find and set a bulls-eye and don’t let the manager change it if she underperforms. Some thoughts on the bulls eye of manager measurement:

i) All managers should be compared to inflation and a bond index. Investing in stocks, real estate, hedge funds, and private equity is sexy but silly if these asset classes and managers underperform inflation or bonds for any 3-year period or longer. Inflation and bonds are absolute benchmarks for all risk assets to beat; don’t let managers play mental jujitsu with you and try to convince you otherwise. Beyond inflation and a bond index, managers should only be compared to a single risk index.

ii) Don’t let managers pick multiple indexes that are economically very different. Managers will then cherry pick the best index in his communications and claim victory. I’ve seen dozens of “top” managers do this. The S&P 500 is quite different than the Wilshire 5000 or the MSCI All-Country World Index. Many absolute return hedge fund managers use the S&P 500, the MSCI ACWI, and the US Barclays Bond Aggregate together. However, these are three very different indexes with low or negative correlations. Hence one index will always do poorly as the others do well. The crafty but unscrupulous manager will compare his returns to the worst index. The heroic and honest manager, if she chooses all three, will compare her returns to the best performing index for any period. Yet beating all three in nearly all periods is impossible and shouldn’t be the standard – it’s like asking for a spouse with movie star looks, Einstein’s brains, Oprah’s empathy, and eternal unconditional love and devotion to you. Hence honest managers should only be compared to a single risk index.

iii) A risk index should be as broad as a manager’s legal/strict mandate, and not narrow like what the manager voluntarily chooses to invest in any period. A manager who has the mandate to invest in global stocks but chooses to limit herself to US stocks has made a country/geographical bet. Don’t let her choose the S&P 500 as her index (note to Warren Buffett – pick a broader index!). If a manager has a mandate to invest in 3 countries, her benchmark should be the best-performing broad equity index from those three countries in that time period, or a static, blended benchmark of three indexes.

iv) Simplicity and openness: Avoid using too many benchmarks (more than 3) or complicated blended benchmarks, as people have a hard time following them (due to bounded rationality). Also, non-proprietary benchmarks (like those from Cambridge Associates or other niche firms) usually don’t release verifiable data and hence shouldn’t be trusted or used. For example, a private equity firm is better off comparing its returns to a broad public equity index plus an illiquidity premium (say the Wilshire 5000 plus 400 basis points), rather than comparing itself to the opaque Cambridge Associates Private Equity Index.

The basic point is that every investing strategy taking risk should have a benchmark set beforehand. At a minimum, a manager must beat inflation and bonds, carefully defined, over a three and five year period. Beyond that, it takes some creative thinking to come up with a benchmark.

For example, a pure global macro fund can theoretically invest in any security, country, or asset class. Hence even a traditional 60/40 benchmark of the S&P 500 and US Barclays Aggregate is too limiting for a macro manager. It’s like playing basketball without have to bounce a ball, respect the court boundaries, or follow any rules. Any idiot macro manager should be able to beat a single country’s equity index (but strangely, few do!). Since the vast majority of global wealth is spread between stocks, bonds, and real assets, perhaps a macro manager should be measured against a benchmark blend of the MSCI ACWI, the Barclays Global Aggregate Bond Index, and the S&P/Citigroup World REIT Index. For simplicity, all three indexes are global, liquid, transparent, and widely known – a 33% split avoids the problem of annually re-measuring the balance of global wealth. Of course the REIT index isn’t a great measure of global real assets, but using three other niche benchmarks to measure real assets would make the blend unbearably difficult to understand.

5) How to beat the chess grandmaster Bobby Fisher
Bobby Fisher was one of the great chess grandmasters. At 13, he won the “Game of the Century.” He was the youngest US grandmaster, dominated world chess championships in the 1960s, and wrote a wonderful beginner’s book on playing chess, called “Bobby Fisher Teaches Chess.” So how do you beat Bobby Fisher? Here’s the secret:

To beat Bobby Fisher, don’t play him in chess. Pick something else: basketball, Hollywood trivia, ballroom dancing, stage acting, arm wrestling, or paintball.

That is really the secret that most money managers use. They tell you they’re going to “make money” for you. That’s easy, like thumb wrestling with Bobby Fisher. The real difficulty is to consistently beat inflation, a bond index, and a risk index. Very few managers can do that.

Of course, evaluating investment managers is more complicated:
-Managers can make dodgy asymmetric bets where the tail risk is a bulldozer (selling out-of-the-money options), or can buy securities that go from being very liquid to frozen (CDS).
-Managers can also play performance games where they post great returns with small amounts of capital (make $30 million on $100 million), and then raise lots of money to destroy much more (raise $10 billion only to lose $4 billion). They prove themselves dangerous to society. Unfortunately, many famous hedge fund and mutual fund managers fall into this category.
-Managers can make money by doing unethical things. If you’re not a sociopath, social and ethical goals matter. You may not want a strategy with high returns that devastates the urban poor or some other part of society (what were subprime investors thinking?).
But these are advanced bulls eye topics.

Investing to make money isn’t enough. You have to beat inflation, a diversified bond index, and a well-chosen risk index. If you can’t beat the indexes, just buy the indexes (at low cost) and sleep soundly.

Your bemused investor who has seen far too many bogus manager pitches,
Copyright 2009 Risk Over Reward. All Rights Reserved

You have permission to publish this article electronically or in print as long as the following is included:
Risk over Reward: A conversation about intelligent investing – we discuss the nature of risk and uncertainty, macroeconomics, security valuation, and how to think about markets and invest profitably

Wednesday, November 4, 2009

Party Like It's 2007 - Ari Paul

If you’ve misplaced your calendar, you could be forgiven for thinking it’s the fall of 2007. Big banks are again paying out record bonuses to speculating traders. I’m again receiving letters from banks begging me to borrow money for 0% in special promotional offers. We’re again offering 0% down mortgage loans to people with poor credit (and like last time, it’s being encouraged by congress). There is again widespread talk of how the US dollar must eventually collapse and endless optimism about commodities.

What’s going on? Are investors/citizens/congress really that shortsighted? Ah, the remarkable power of liquidity. When the fed (and central banks around the world) throw enough money at people, those people are given tremendous incentives to gamble. Now, the gamblers don’t see themselves as gamblers. Rather, they rationalize that this or that asset market is cheap. They find convincing analysis by smart economists to justify stockpiling commodities or buying corporate bonds on margin. Similarly, when congress writes a blank check to a construction company, they’ll always find a highway that needs fixing.

The harder thing to explain is the near complete lack of response by the president and congress to the rising populist anger. For better or worse, responding to public sentiment is usually what politicians do best. So why is the modus operandi of the financial sector almost completely unchanged? After every major banking collapse in history (and there have been many), there was a period of conservatism when banks went back to the basic business of taking deposits and making loans. I think the answer is that Congress has just moved slowly, but the regulation is coming, and it will be very heavy. The financial firms donate a lot of money, but every person still only gets one vote. The main street narrative is clear – the financial sector was at least partly responsible for getting us into this mess and they haven’t taken their fair share of the pain. Over the next year, we’ll see that narrative translated into heavy handed legislation.

Aside from the additional regulation, I think we’re in for a repeat of many of the other changes that followed 2007. Just as the speculative bubble in 2007 was largely caused by excess credit, the recent rallies in “risky assets” have the same source. There’s no limit to how much money the fed can print, but I believe the tide is turning politically and we’ll start seeing credit tighten over the next 6 months. For example, today the front page of the WSJ featured an article about how economists and government officials worldwide believe bubbles are forming ( As I wrote 3 months ago, I expect the catalyst for a broad sell off to be the withdrawal of liquidity by central banks. It looks like the credit tightening is growing nearer.

An interesting social trend that's gaining steam is a push towards isolationism. In the last couple months, both liberal and conservative pundits have started calling for us to pull out of both Iraq and Afghanistan (e.g. Fareed Zakaria, Thomas Friedman, George Will). Another trend just starting is "age warfare." People under 40 are asking, "hasn't my generation's future been mortgaged enough to support the overspending of our parents and grandparents? Why are we taking on yet more debt to mail seniors checks?" We're only beginning to see the economic and social fallout from last year's crisis.