The Alchemy of Risk

Here is a recurring theme from this blog: “risk can never be destroyed, it can only be transformed and laid off on someone else.”

Or, in the words of the late, great Marty Whitman: “someone has to pay for lunch, and I don’t want it to be me.”

Often people think they’ve destroyed risk when they buy a financial product with a guarantee attached. In finance, “guarantee” is just a fancy word for “promise.” When you buy a financial product with a guarantee attached, you’re swapping market risk for something else. Usually it’s a stream of payments with its own set of risks.

The person selling you the stream of payments will tell you that you’ve gotten rid of your risk. And you have, to an extent. You’ve gotten rid of A risk. You’ve traded your market risk for credit risk (your counterparty might not make good on their promise) and purchasing power risk (your stream of payments might not keep up with inflation).

Some of you will say, “but the counterparty is contractually obligated to keep is promise!”

To which I say, “so are bond issuers and individual borrowers. Yet they default all the time. Sometimes they even commit fraud.”

Others will say, “you don’t know what you’re talking about! The government has insurance funds for deposits and pensions!”

To which I say, “promises, promises, all the way down.”

How does the government fund its promises? With tax revenue, partly. But more importantly, with debt. Like I said–promises, all the way down. Dollar bills are themselves promises. What is the “full faith and credit of the United States government” but an elaborate series of promises?

Anyway, for normal people the most common example of “risk transformation” would be buying an annuity or whole life policy from an insurance company. But there are more exotic examples.

Banks like to sell structured notes to their wealth management clients. These are difficult products for the average person to understand. They usually promise a return based on the price performance of some index, subject to certain limitations. For example there will be a guaranteed minimum return and a cap on the high end.

(Notice that I said price performance. If you buy a structured note, no dividends for you!)

Banks like this opacity because the complexity makes it easy for them to bake profits into the structures, which are literally designed by mathematicians (actuaries). The products are sold based on the guaranteed minimum return, and the chance of modest upside. As the buyer, you overpay for the downside protection (the guarantee). When you buy a structured note, you are basically lending the bank money so it can write options and eke out some trading profits. In return you get a more bond-like risk profile.

Meanwhile, you are an unsecured creditor of the bank. If the bank goes bust, your investment is toast. So much for guarantees. Get in line with the rest of the unsecured lenders. Ask the people who bought structured notes from Lehman Brothers how it worked out for them.

In general, the more complicated the product, the worse a deal you are getting. Of course, there can be good reasons to swap market risk for a guaranteed stream of payments. Just because you overpay for downside protection doesn’t make you a sucker.

But lunch is definitely on you.

Shenanigans! “Index Investing Distorts Valuations” Edition

Here is an oft-repeated meme that has begun to grind my gears. Here it is again, from the FT’s Megan Greene:

Passive investments, such as exchange traded funds (ETFs) and index funds, similarly ignore fundamentals. Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher. This creates a piling-on effect as funds buy more of these increasingly expensive stocks and less of the cheaper ones in their indices — the polar opposite of the adage “buy low, sell high”. Risks of a bubble rise when there is no regard for underlying fundamentals or price. It is reasonable to assume a sustained market correction would lead to stocks that were disproportionately bought because of ETFs and index funds being disproportionately sold.

The idea that index investors cause valuation disparities within indices is a myth. It is mainly trotted out in difficult client conversations about investment performance. For the purposes of this discussion, let’s restrict the definition of “passive” to “investing in a market capitalization weighted index,” like the Russell 2000 or S&P 500. There is a simple reason everyone who makes this argument is categorically, demonstrably wrong:


It is correct to say things like, “S&P 500 stocks are more expensive than Russell 2000 stocks because investors are chasing performance in US large caps by piling into index funds.”

It is correct to say things like, “S&P 500 stocks are more expensive than OTC microcaps outside of the index because investors are chasing performance in US large caps by piling into index funds.”

It is demonstrably false to say, “NFLX trades at a ridiculous valuation relative to the rest of the S&P 500 because investors are chasing performance in US large caps by piling into index funds.”

Index funds buy each security in the index in proportion to everything else. Their buying doesn’t change the relative valuations within the index.

Here is how index investing works:

1. Active investors buy and sell stocks based on their view of fundamentals, supply and demand for various securities, whatever. They do this because they think they are smart enough to earn excess returns, which will make them fabulously wealthy, The Greatest Investor Of All Time, whatever. As a result, security prices move up and down. Some stuff gets more expensive than other stuff.

2. Regardless, the markets are not Lake Wobegon. All of the active investors can’t be above average. For every buyer there is a seller. If you average the performance of all the active investors, you get the average return of the market.

3. Index investors look at the active investing rat race and think, “gee, the market is pretty efficient thanks to all these folks trying to outsmart each other in securities markets. Let’s just buy everything in the weights they set. We are content to get the average return, and we will get it very cheaply.”

4. Index investors do this.

Despite what we in investment management like to tell ourselves, index investors are rather clever. They are trying to earn a free lunch. They let the active investors spend time, money and energy providing liquidity and (to a much lesser extent) allocating capital for real investment in primary market. They just try to piggyback on market efficiency as cheaply as possible.

In my experience, some index investors like to think of themselves as somehow acting in opposition to active managers. This, too, is demonstrably and categorically false. Index investors’ results are directly and inextricably tied to the activity of active investors setting the relative weights of securities within the indices. That activity is what determines the composition of the index portfolio.

It’s a symbiotic relationship. Index investing only “works” to the extent the active investors setting the relative weights within the index are “doing their jobs.” When the active managers screw up, bad companies grow in market capitalization and become larger and larger weights in the index. At extremes, the index investor ends up overexposed to overvalued, value-destroying businesses. This happened with the S&P 500 during the dot-com era.

Now, flows of passive money certainly can distort relative valuations across indices, and, by association, across asset classes. When it comes to asset allocation, almost everyone is an active investor. Even you, Bogleheads. Otherwise you would own something like ACWI for your equity exposure.

A running theme of this blog is that there are no free lunches. Someone is always paying for lunch. These days, it’s the active managers. But that doesn’t mean the passive folks will always enjoy their meal.

Great Expectations

Not a good day for FANG. Facebook in particular:

Source: Google

Let’s cut to an investor reaction shot, courtesy of the FT. This made me laugh so hard I had to screencap it for posterity:

Source: Financial Times

Uh oh. Looks like someone was just plugging management guidance into her model. Or forgot to fade revenue growth and returns on capital. Or both.

Look. Schadenfreude aside, FB is a good business with a good product. As far as I’m concerned, the jury’s out on the valuation (of the so-called FANG stocks I have very strong opinions on NFLX and AMZN, but not so much on GOOG and FB). I have no real opinion on the long-run prospects for the business. Today’s price action is simply a helpful reminder that good businesses selling good products can still be bad investments if you overpay.

In my experience, that last bit is the hardest thing about investing for laypeople to understand. Most people understand what makes a good product. Somewhat fewer understand what makes a good business. But almost no one outside finance understands why overpaying can overwhelm everything else.

Let’s explore this further. Here is the most important chart in all of fundamental investing:

Source: Demonetized Calculations

What are you looking at?

You’re looking at the valuation life cycle of a business (an exceptional one, btw) with the following characteristics:



I generated the graph with a simple model called a fundamental H model. In an H model, a company’s life is divided into two parts: an “advantage period” featuring excess growth and returns on capital, and a “steady state” period where the company simply earns its cost of capital.

The intuition here is really, really simple. It’s so simple I’m not going to bother going into the details of what an H model actually looks like.


Companies with exceptional growth and profitability attract competitors. Competition decreases profitability and slows growth (more companies are fighting over the same pool of customers). As competition drives down future growth and profitability, every company in the space becomes less valuable. Or, in another variation, a market simply becomes saturated, and there is very little growth left available. Or, new technology is developed that makes a company obsolete. You can go on and on. The variations are endless.

Some businesses are better at defending their profitability and growth (they have “moats”). If you are good at identifying strong moats, you can make a lot of money. This has worked out well for Warren Buffett. Especially since he was able to lever his bets with insurance float. All else equal, you should be willing to pay more for a business with a “wide moat.” How much? Believe it or not, figuring that out is the fun of it. It’s the game all of us long-term, fundamental investors are playing.

Likewise, in some industries with only a few large players, the players are smart enough to realize they should protect their profit pools, not undercut their competitors on price just to gain market share (this is uncommon).

Also, it’s technically possible to grow your way out of a contracting valuation. If the E in P/E grows large enough, fast enough, you can still make money even if the ratio shrinks. You could have paid several hundred times earnings for WMT stock back in the day, and still made money. But only a select group of businesses have this ability, and personally I think they are far more difficult to spot ex ante than people like to admit.

Anyway, all that’s beside the point.

The point is that growth and profitability inevitably fade to some degree. And when they do, valuations de-rate. When people overpay for businesses, what they are doing (whether they realize it or not) is being overly optimistic about the magnitude and the rate of the fade.

Basically, they are forgetting how capitalism works.

Disclosure: Small positions in FB and GOOG, via a mutual fund manager. But less than 1 bp on a lookthrough basis. So, practically speaking, no positions in anything referenced in this post.

Book Review: The Lessons Of History By Will & Ariel Durant

lessons_of_history_durantI found The Lessons of History, by Will and Ariel Durant, courtesy of Ray Dalio. (Okay, actually a Reddit ask-me-anything chat featuring Ray Dalio) The Durants are best known for their epic eleven volume history, The Story of Civilization, for which they received a Pulitzer Prize in 1968 and a Presidential Medal of Freedom in 1977.

The Lessons of History is a distillation of the key themes of the longer work. It’s the cliffs notes for The Story of Civilization.


As you read, a couple of key premises emerge: 1) history is a competitive evolutionary process, and 2) that process is cyclical.

A key driver of these cycles is the tendency for market systems to create wealth inequality over time. There isn’t anything nefarious about that. I don’t read it as a pejorative, either. It’s just the way things work. Mostly because wealth, when managed properly, compounds over time. It’s not just compound interest I’m talking about here. It’s economic opportunity more generally.

The Durants sum this up in a single, beautiful little paragraph (my favorite in the whole book):

We conclude that the concentration of wealth is natural and inevitable, and is periodically alleviated by violent or peaceable partial redistribution. In this view all economic history is the slow heartbeat of the social organism, a vast systole and diastole of concentrating wealth and compulsive recirculation.

An entire chapter on socialism follows. “[H]istory so resounds with with protests and revolts against the abuses of industrial mastery, price manipulation, business chicanery, and irresponsible wealth,” the Durants observe. “These abuses must be hoary with age, for there have been socialistic experiments in a dozen countries and centuries.”

One example, from China:

Wang Mang (r. A.D. 9-23) was an accomplished scholar, a patron of literature, a millionaire who scattered his riches among his friends and the poor. Having seized the throne, he surrounded himself with men trained in letters, science, and philosophy. He nationalized the land, divided it into equal tracts among the peasants, and put an end to slavery. Like Wu Ti, he tried to control prices by the accumulation or release of stockpiles. He made loans at low interest to private enterprise. The groups whose profits had been clipped by his legislation united to plot his fall; they were helped by drought and flood and foreign invasion. The rich Liu family put itself at the head of a general rebellion, slew Wang Mang, and repealed his legislation. Everything was as before.

“Skin in the game,” Taleb might comment.

The relationship between free market capitalism and socialism is cyclical. It’s a yin and yang type of deal. When inequality under capitalism causes enough friction, and social cohesion decays enough, people gravitate toward the utopian promises of socialism. Then, as the socialist system ossifies under the dual pressures of complexity and inefficiency, it becomes vulnerable to unexpected shocks. Eventually, people overturn the socialist system and return to free market capitalism. The cycle begins again.

The last bit of the book is devoted to the idea of “progress.” If all history is cyclical, does progress actually exist? If so, how do we measure it? I won’t spoil it for you, since this last chapter does a nice job of tying everything together.

Who Should Read This Book?

Literally everyone should read this book. It is a short read, easy to follow and relevant to every human being on the planet. This is the type of “Big Idea” book that helps you see the world as it is, rather than how you want to see it.

Live By The Sword, Die By The Sword

Good management teams are first and foremost good storytellers. They’re shapers of reality. I don’t care whether you’re Warren Buffett, Elon Musk or Reed Hastings. If you are the Big Guy (or Big Gal) most of your job is storytelling. You spend most of your time telling stories to your stakeholders. Employees. Customers. Investors.

What’s truly amazing about Reed Hastings’s ability as a CEO/storyteller is how he’s managed to make Netflix’s free cash flow burn irrelevant. Here’s a screenshot directly from the company website:

Source: NFLX website

This is a company burning billions in cash a year, that is utterly dependent on the amity and goodwill of the capital markets (specifically, the high yield debt market) to support its continued existence.

And no one cares.

The reason no one cares is Reed Hastings is a great CEO/storyteller. He’s convinced the market it’s subscriber growth and not free cash flow that matters.

Well, yesterday NFLX (badly) missed expectations for subscriber growth. The result?

Source: Google

Live by the sword, die by the sword, as the saying goes. This is the kind of reaction you get when you train the market on a certain narrative, and then that narrative is called into question. The market freaks out.

This is something short sellers understand deeply and intuitively. If you are a short seller who doesn’t understand this deeply and intuitively, you’re not going to last very long.

A short needs to understand the narrative driving a stock. The time to short a stock is when the narrative breaks. When a narrative breaks, investors start casting around, looking for a new narrative. If the CEO can’t get control of the narrative again, they might start to fixate on things like profitability and cash flows and leverage.

Of course, a good management team will have a new narrative ready to go to replace the old one. In NFLX’s case, they are talking about the limitations of their internal forecasting methods. Short selling is a hard life.

I literally have no opinion on NFLX’s subscriber growth numbers. But I do understand the narrative around them, and the purpose it serves.

Once you start looking for this stuff, you see it everywhere. Tesla is the best example, but it’s a more controversial stock than NFLX. The reason Elon Musk is coming apart at the seams is he’s losing control of TSLA’s narrative. That’s bad for TSLA, which is going to have to pay down or refi about $7 billion worth of debt in the next couple of years.

For these large cap cash incinerators, narrative is a matter of life and death.

Disclosure: No position in either NFLX or TSLA.

Our World In Meta-Games

Source: Brandt Luke Zorn via Wikipedia

The world is a complicated place. A good way of attacking that complexity is to view the world as a nested series of games and meta-games.

Ben Hunt at Epsilon Theory wrote an excellent post about meta-games in financial markets a while back, specifically in the context of financial innovation. While I’m going to take a slightly different angle here, his illustration of how a meta-game works is useful as a jumping off point.

It involves the coyotes that “skirmish” with the residents of his town:

What’s the meta-game? It’s the game of games. It’s the larger social game where this little game of aggression and dominance with my wife played out. The meta-game for coyotes is how to stay alive in pockets of dense woods while surrounded by increasingly domesticated humans who are increasingly fearful of anything and everything that is actually untamed and natural. A strategy of Skirmish and scheming feints and counter-feints is something that coyotes are really good at. They will “win” every time they play this individual mini-game with domesticated dogs and domesticated humans shaking coffee cans half-filled with coins. But it is a suicidal strategy for the meta-game. As in literally suicidal. As in you will be killed by the animal control officer who HATES the idea of taking you out but is REQUIRED to do it because there’s an angry posse of families who just moved into town from the city and are AGHAST at the notion that they share these woods with creatures that actually have fangs and claws.

For simplicity’s sake, I’m going to write about four interrelated layers of “games” that influence financial markets. Imagine we are looking at a set of Russian nesting dolls, like the ones in the image at top, and we are working from the innermost layer out. Each successive layer is more expansive and subsumes all the preceding layers.

The layers/ games are:

1. The Security Selection Game

2. The Asset Allocation Game

3. The Economic Policy Game

4. The Socio-Political Power Game

Each of these games is connected to the others through various linkages and feedback loops.

Security Selection

This is the most straightforward, and, in many ways, the most banal of the games we play involving financial markets. It’s the game stock pickers play, and really the game anyone who is buying and selling assets based on price fluctuations or deviations from estimates of intrinsic value is playing. This is ultimately just an exercise in buying low and selling high, though you can dress it up any way you like.

While it often looks a lot like speculation and gambling, there is a real purpose to all this: price discovery and liquidity provision. The Security Selection Game greases the wheels of the market machine. However, it’s the least consequential of the games we will discuss in this post.

Asset Allocation

Asset Allocation is the game individuals, institutions and their financial advisors play as they endeavor to preserve and grow wealth over time. People often confuse the Security Selection Game with the Asset Allocation Game. Index funds and ETFs haven’t helped this confusion, since they are more or less securitizations of broad asset classes.

At its core, the Asset Allocation Game is about matching assets and liabilities. This is true whether you are an individual investor or a pension plan or an endowment. Personally, I think individual investors would be better served if they were taught to understand how saving and investing converts their human capital to financial capital, and how financial capital is then allocated to fund future liabilities (retirement, charitable bequests, etc). Unfortunately, no one has the patience for this.

The Asset Allocation Game is incredibly influential because it drives relative valuations across asset classes. As in Ben Hunt’s coyote example, you can simultaneously win at Security Selection and lose at Asset Allocation. For example, you can be overly concentrated in the “best” stock in a sector that crashes, blowing up the asset side of your balance sheet and leaving you with a large underfunded liability.

I sometimes meet people who claim they don’t think about asset allocation at all. They just pick stocks or invest in a couple of private businesses or rental properties or whatever. To which I say: show me a portfolio, or a breakout of your net worth, and I’ll show you an asset allocation.

Like it or not, we’re all playing the Asset Allocation Game.

Economic Policy

The Economic Policy Game is played by politicians, bureaucrats, business leaders and anyone else with sociopolitical power. The goal of the Economic Policy Game is to engineer what they deem to be favorable economic outcomes. Importantly, these may or may not be “optimal” outcomes for a society as a whole.

If you are lucky, the people in power will do their best to think about optimal outcomes for society as a whole. Plenty of people would disagree with me, but I think generally the United States has been run this way. If you are unlucky, however, you’ll get people in power who are preoccupied with unproductive (yet lucrative) pursuits like looting the economy (see China, Russia, Venezuela).

The Economic Policy Game shapes the starting conditions for the Asset Allocation Game. For example, if central banks hold short-term interest rates near or below zero, that impacts everyone’s risk preferences. What we saw all over the world post-financial crisis was a “reach for yield.” Everyone with liabilities to fund had to invest in progressively riskier assets to earn any kind of return. Cash moved to corporate bonds; corporate bonds moved to high yield; high yield moved to public equity; public equity moved to private equity and venture capital. Turtles all the way down.

A more extreme example would be a country like Zimbabwe. Under Robert Mugabe the folks playing the Economic Policy Game triggered hyperinflation. In a highly inflationary environment, Asset Allocators favor real assets (preferably ones difficult for the state to confiscate). Think gold, Bitcoins and hard commodities.

This is no different than Darwin’s finches evolving in response to their environment.

Do you suppose massive, cash-incinerating companies like Uber and Tesla can somehow exist independent of their environment? No. In fact, they are products of their environment. Where would Tesla and Uber be without all kinds of long duration capital sloshing around in the retirement accounts and pension funds and sovereign wealth funds and Softbank Vision Funds of the world, desperate to eke out a couple hundred basis points of alpha?

Insolvent is where Uber and Tesla would be.

In general, western Economic Policy players want to promote asset price inflation while limiting other forms of inflation. There are both good and selfish reasons for this. The best and simultaneously most selfish reason is that, to a point, these conditions support social, political and economic stability.

However, the compound interest math also means this strategy favors capital over labor. This can create friction in society over real or perceived inequality (it doesn’t really matter which–perception is reality in the end). We’re seeing this now with the rise of populism in the developed world.

The Sociopolitical Power Game

Only the winners of the Sociopolitical Power Game get to play the Economic Policy Game. In that sense it is the most important game of all. If you are American, and naïve, you might think this is about winning elections. Sure, that is part of the game. But it’s only the tip of the proverbial iceberg.

This game really hinges on creating and controlling the narratives that shape individuals’ opinions and identities. If you are lucky as a society, the winners will create narratives that resemble empirical reality, which will lead to “progress.” But narratives aren’t required to even faintly resemble reality to be effective (it took me a long time to understand and come to grips with this).

You could not find a more perfect example of this than President Donald Trump. People who insist on “fact checking” him entirely miss the point. Donald Trump and his political base are impervious to facts, precisely because Trump is a master of creating and controlling narratives.

Ben Hunt, who writes extensively about narrative on Epsilon Theory, calls this “controlling his cartoon.” As long as there are people who find Trump’s narratives attractive, he will have their support. Facts are irrelevant. They bought the cartoon. (“I just like him,” people say)

It’s the same with Anti-Vaxxers. Scientific evidence doesn’t mean a thing to Anti-Vaxxers. If they cared even the slightest bit about scientific evidence, they wouldn’t exist in the first place!

I’m picking on Trump here because he is a particularly prominent example. The same can be said of any politician or influential figure. Barack Obama. Angela Merkel. JFK. MLK. I think MLK in particular is one of the more underrated strategists of the modern era.

Here is Sean McElwee, creator of #AbolishICE, commenting to the FT on effectively crafting and propagating narratives:

“You make maximalist demands that are rooted in a clear moral vision and you continue to make those demands until those demands are met,” said Mr McElwee. “This is an issue where activists have done a very good job of moving the discussion of what has to be done on immigration to the left very quickly.”

If you want to get very good at the Sociopolitical Power Game, you have to be willing to manipulate others at the expense of the Truth. It comes with the territory. Very often the Truth is not politically expedient, because our world is full of unpleasant tradeoffs, and people would prefer not to think about them.

I have been picking on the left a lot lately so I’ll pick on free market fundamentalists here instead. In general it is not a good idea to highlight certain features of the capitalist system to the voting public. Creative destruction, for example. In Truth, creative destruction is vital to economic growth. It ensures capital and labor are reallocated from dying enterprises to flourishing enterprises. Creative destruction performs the same function wildfires perform in nature. Good luck explaining that to the voters whose changing industries and obsolete jobs have been destroyed.

Because of all this, many people who are very good at the Sociopolitical Power Game are not actually “the face” of political movements. These are political operatives like Roger Stone and Lee Atwater, and they are more influential than you might think.

The Most Important Thing

There is a popular movement these days to get back to Enlightenment principles and the pursuit of philosophical Truth. I’m sympathetic to that movement. But I’m not sure it really helps you understand the world as it is.

In the world as it is, people don’t make decisions based on Truth with a capital T. In general, people make decisions based on: 1) how they self-identify; and 2) what will benefit them personally. Rationalization takes care of the rest.

When have you heard an unemployed manufacturing worker say, “yeah, it’s a bummer to be out of a job but in the long run the aggregate gains from trade will outweigh losses like my job”?

In the world as it is, people operate much more like players on competing “teams.” They want their team (a.k.a tribe) to win. They are not particularly concerned with reaching stable equilibria across a number of games.

And that tribal competition game is probably the most important meta-game of all.

The Incredible Flattening Yield Curve

This is a pretty amazing image, courtesy of J.P. Morgan Asset Management:

Source: J.P. Morgan Asset Management (obviously)

People are really starting to worry the Fed is going to invert the curve. Historically, an inverted curve (short rates above long rates) has been a pretty good recession indicator. I don’t have a particularly strong opinion about the direction of interest rates, especially now that we are above 2% on the 2-Year. But I do think this chart is telling us something.

If the curve is basically flat from 7 years on out to 30 years, that is not exactly a ringing endorsement of long-term growth and inflation prospects. I’ve heard from some fixed income people that it’s demand for long-dated paper from overseas buyers holding the 30-year yield down. I’ll buy that. But it’s still telling us something about supply and demand for capital along various time horizons.

Namely: we’ve got an awful lot of long duration capital out there looking for a home, and not enough opportunities to absorb it all.