Vanguard is worried about the structural flaws in indexed products that allow sophisticated traders to profit from their rules-based rebalancing trades. Only Vanguard doesn’t say it that way, because, let’s face it, it’s always easier to blame hedge funds and high frequency traders. The FT reports:
Vanguard fears that ‘’predators’’ are taking advantage of exchange traded funds at the expense of retail investors and hopes that an expected overhaul by US regulators will not mandate perfect transparency for the booming $4.8tn industry.
ETFs try to track indices and markets such as the S&P 500, the Bloomberg Barclays Aggregate bond benchmark or the price of gold as closely as possible, giving investors cheap exposure to a wide array of assets.
The vast majority disclose their holdings daily and if an index they track changes, they must then adjust their holdings before the close of trading. The daily shifts in markets means ETFs are vulnerable to opportunistic traders such as hedge funds and high-frequency trading firms who can try to “front-run” their efforts at rebalancing their holdings.
Vanguard, the industry’s second-biggest provider, chooses to disclose its ETF holdings with a one-month lag to avoid the danger of front-running, and is worried that a new rule from the Securities and Exchange Commission could force it to do so on a daily basis.
Tim Buckley, who took over at Vanguard this month, likens the predicament faced by ETF providers to the children’s tale of Little Red Riding Hood, who told the wolf where she was going, allowing him to take a shortcut to devour her unsuspecting grandmother.
“We don’t want to see full transparency for ETFs,” he told journalists at the sidelines of a conference last week. “If they know where you’re going they can ambush you. If you buy all at the close you have perfect tracking, but billions of dollars of investor money is destroyed. The money goes to the predators, and you won’t even see it.’’
Little Red Riding Hood? Seriously?
This isn’t a knock on Vanguard or its products (hell, I own Vanguard products). This is just calling a spade a spade. Pro tip: if you don’t want sophisticated traders “preying” on the inefficiencies introduced by your systematic, indexed strategy, DON’T INVEST USING A SYSTEMATIC, INDEXED STRATEGY.
Regular readers will know we treasure our useless degrees around here. Happily, we are not the only ones willing to evangelize for the value of studying worthless, outmoded subjects such as English literature, philosophy, religion and language.
Recently the financier Bill Miller donated $75m to the study of philosophy at Johns Hopkins University. The size of the gift made headlines, but few stopped to remark on the other surprise in the story: that someone who studied philosophy went on to create a fortune estimated at about $1bn — and thought this study valuable enough to encourage others to do the same.
Mr Miller is anomalous, obviously. If you really want to understand how to create an enormous fortune from nothing, you should look to someone like George Soros, who studied . . . philosophy. Or consider billionaire investor Carl Icahn, who resigned last year as an adviser to Donald Trump over potential conflicts of interest. He graduated from Princeton with a thesis on “The Problem of Formulating an Adequate Explication of the Empiricist Criterion of Meaning”: another philosopher. Clearly not all philosophers are moral philosophers. But they know how to think.
The brain is like any other muscle: working it makes it stronger, faster, more flexible. Being able to hypothesise, think conditionally and reason inductively as well as deductively are all features of the theoretical training that goes on in good humanities departments — and not only there. The most advanced work in mathematics moves away from real numbers toward imaginary and irrational numbers. That’s where the difficult thinking occurs: in the realm of the imaginary, which is by no means antithetical to the logical.
Let me be clear: useless degrees do absolutely NOTHING to prepare you for schlepping around in an entry level position in any industry.* In reality, most entry level jobs in most industries can be learned through apprenticeship. However, employers like to use education as an easy screen to narrow down pools of job applicants. This is no different than an investor screening stocks trading on EV/EBITDA multiples over 5x out of her investment universe. Yes, she will miss some good companies. That’s not the point. She’s using the screen to narrow the field to a manageable number. She doesn’t have the time, energy and resources to model every company in the Russell 3000.
As with good companies trading on “bad” multiples, screening processes can make it difficult for people holding useless degrees to get their feet in the door initially. For rich people it’s not so bad, because they’ve got lots of wastafrom knowing other rich people. The rest of us have got to build networks and demonstrate our ability to add value. This can be a circuitous path. I started my career in finance as a Customer Service Associate in retail banking. Paying dues like this is no fun and can cause us useless degree holders to despair at times.
However, I contend that a useless degree holder with sufficient motivation is exposed to significant positive convexity in his career / earnings progression over time.
As your career progresses, your job is less and less about executing straightforward tasks that can be taught through regimented training and checklists. It becomes more about thinking strategically and (dare I say it?) creatively to solve business problems. The potential rewards for thinking strategically and creatively are much, much greater than those for being really good at executing straightforward tasks. Roles that require strategic thinking tend to be roles involving risk taking and risk management, with variable compensation schemes that scale up massively in line with business results. Owner, Partner, CEO, COO, Portfolio Manager, Line Manager, etc.
Hence, the returns to a useless degree are very small relative to other, narrowly focused degrees for several years. If there is a return at all. Until one day you work your way into a role that demands “being able to hypothesize, think conditionally and reason inductively as well as deductively” (such as running a hedge fund). Then those returns grow exponentially.
That, friends, is the power of convexity.
Chris Cole, who I mentioned above, put out a great white paper about convexity as relates to George Lucas’s profits from the Star Wars franchise. Prior to Star Wars, everyone “knew” film merchandising rights were worthless. Lucas cleverly made a deal where he took a much lower directing fee (the “best” way to get paid at the time) in exchange for merchandising rights. We all know how that played out…
Source: Artemis Capital Management
Now, when people asked me where I studied finance, I delight in telling them I was a dual major in English and German. “Your CFA charter is what gets you hired,” I tell them. “The English degree is what gets you promoted.”
* Pro Tip: Adding value as an entry level employee is super simple and revolves entirely around making your boss’s life easier by proactively solving problems, while simultaneously being someone your co-workers enjoying working with. That’s literally all there is to it.
I am filing this under books, though really it is a recommended reading list. Will also probably make this a dedicated page so I can add to it over time.
General Business / Finance / Economics
FT Alphaville – Alphaville is the markets blog of the Financial Times. Access is free if you register. In addition to original research and reporting the team assembles very nice link lists. One of my first stops every morning.
Stratechery – Deep analysis of tech industry businesses, products and trends.
Investing (Mass Appeal)
These are websites and blogs with an investing focus that are likely to appeal to “normal people” as well as professionals and serious amateurs.
The Aleph Blog – Longtime writer and money manager David Merkel explains complex topics simply. David has been writing a long time so going back through his old posts is like a treasure hunt. He has done some fantastic series on his experiences managing money over the years. David would also fit in on the Investing (Wonkish) list.
Morningstar – Lame, I know. But there are occasionally some real gems here. Especially from Russ Kinnell, John Rekenthaler and Jeff Ptak.
Investing (Wonkish)
These are websites and blogs with an investing focus that are likely to appeal more to professionals or serious amateurs than “normal people.”
Bronte Capital – Commentary and the occasional investment thesis from hedge fund manager John Hempton. John runs a long/short portfolio.
Musings on Markets – Blog of NYU Professor Aswath Damodaran. I have heard Damodaran called “the father of valuation.” A must-read for DCF and modeling junkies. Professor Damodaran also puts together phenomenal data sets that are freely available to the public.
Philosophical Economics – Deep dives into issues such as capital market forecasting and Bayesian updating. If you you are the kind of person who likes to brew up coffee and settle in for an hour of meaty reading, man oh man is this the blog for you.
Alpha Architect – Wes Gray and his various contributors are all quant, all the time.
Fundoo Prof – Sanjay Bakshi will probably end up being remembered as the Ben Graham of India.
Cable Car Capital – Similar to John Hempton at Bronte Capital, Jacob Ma-Weaver provides commentary alongside investment theses. Runs a long/short portfolio.
SIRF – Investigative reporting on financial fraud and various and sundry other shenanigans by Roddy Boyd. Also, you should read Roddy’s book about AIG.
Base Hit Investing – Similar to Bronte and Cable Car, John Huber provides occasional commentary and investment write-ups. Runs a concentrated portfolio of high quality names.
Personal Finance
These are websites and blogs that primarily deal with the accumulation and management of personal wealth, rather than security selection and portfolio management.
Mr. Money Mustache – In MMM’s own words: “Early Retirement Through Badassity.”
Please forgive me for gleefully indulging in a little confirmation bias. I meet regularly with investment managers, so I feel I have a pretty good handle on sentiment among professional investors (and, by association, their clients). But I am hardly the guy Warren Buffett asked to write a book about investing. As far as I am concerned Howard Marks’s memos are required reading. Hence the gleeful indulgence in confirmation bias.
In this memo, Marks also addresses one of the more damaging impulses investors seem to feel: a desire to view asset allocation decisions in binary terms.
“Volatility is about fear… but extreme tail risk is about horror […] It is not the first act of the horror movie when people start turning into zombies… it is the end of the second act when the hero realizes he is the only person left not a zombie.”
You should read the whole talk. It is fascinating and informative. Bill Nygren is a well-regarded mutual fund manager. This post isn’t meant to impinge on his intelligence or skill (your humble blogger is acutely aware he is a nobody). What this post is meant to show is how some of the most capable investors in the world have been impacted by very low interest rates.
We know from prior analysis that the riskfree rate of interest has varied dramatically over the last 50 years, and that current rates plot on the low end of the historical range. Here is a visual from my discount rate post:
Data Sources: Aswath Damodaran & Michael Mauboussin
So is a 100 bps upward adjustment to the market yield really giving you a conservative hurdle rate?
This is the critical difference between an investor concerned with relative performance versus a benchmark index and an investor concerned with absolute performance that will compound capital at attractive rates over time. Ambitious absolute return goals should be accompanied by high return hurdles. When a hurdle is set at “bond yield + x bps” in a low rate environment it may underprice risk.
(Standard disclaimer applies here. This is not investment advice and it’s not a research report. Don’t blindly follow or believe anything you read on this blog. I could be making all of this up. This is written for informational and entertainment purposes only.)
Annotated ERJ chart with technical indicators. Sources: Morningstar Direct & demonetized account records
This is a follow up to my technical analysis post. In it I will discuss how technical indicators informed my decision to trade shares of Embraer (ERJ). As of 01/17/18, I had earned a 66% IRR on my ERJ trade versus what would have been a 35% cash return from buying and holding the shares. I don’t say this to claim I am the world’s greatest investor or trader. I promise you I am not. I am merely writing to illustrate my thought process and why I believe there are real dollar benefits to looking at the world through both fundamental and technical lenses.
I am an investor first and a trader second (if at all). I seek out long-term investments and will only trade them actively if the following conditions are met:
High confidence in my estimate of the business’s intrinsic value. For ERJ, by playing around with the numbers in a discounted cash flow model I estimated the stock was worth $25-$30/share at time of purchase and could be held for the long term based on a competitive moat and full-cycle returns on capital. For me, intrinsic value serves as the anchor for any trading activity. The less confident I am in my valuation, the less likely I am to trade.
The stock is liquid enough to trade actively. I invest in small caps and even micro caps at times. Even my very small orders can move the market for those securities. If my market impact will be significant I would rather not trade as transaction costs (namely the bid-ask spread) will weigh heavily on returns.
High confidence the stock price is misaligned with intrinsic value,and that the misalignment will correct or over-correct in time. Usually this means there is some element of cyclicality in play, but it can also be the product of non-fundamental buying and selling.
ERJ met all of these criteria.
It is worth mentioning I have a clear idea of what I am trying to achieve when I actively trade a stock: I am looking to improve the IRR on the position versus what I would earn as a buy-and-hold, cash return. I don’t typically trade fully in and out of positions. Rather, I dynamically overweight and underweight positions over time. This is my preferred strategy for investing in well-run, cyclical businesses (poorly run cyclical businesses go bankrupt so are dangerous to own without solid stressed/distressed investing chops).
Embraer’s (Abridged) Fundamental Story
ERJ is a Brazilian aerospace manufacturer. Despite being domiciled in Brazil, most of its revenue is earned abroad, specifically from its North American commercial aviation business, which competes with Bombardier. ERJ also manufactures executive jets and military aircraft. The bulk of today’s revenue and operating profit lie in the commercial aviation business.
ERJ is nearing the end of an investment cycle for the next generation of its successful E-Series jets. Major capex programs create business uncertainty, as well as a near-term drag on financial results, and this is what created the opportunity in ERJ shares. I believe my initial estimate of ERJ’s intrinsic value was higher than the market’s because the market had underestimated the probability of success for the E-2 Series program, and was undervaluing the optionality of the defense and executive jet businesses.
As ERJ’s price approached $24 it was also approaching the lower end of my valuation range ($25-$30). However, the fundamentals of the business hadn’t really changed. Nor had the uncertainty inherent in the E-2 Series program been resolved in a significant way. And with 2018 set to be a “transition” year for the business as the first E-190 jets rolled out to customers, it was very possible a temporary setback such as a weak quarter or E-2 development delay could easily send the shares much, much lower. Given the deteriorating risk/reward ratio, this seemed like a great opportunity to trim the position and lock in some gains. $24 coincided with a resistance level for the stock (though honestly I didn’t draw the lines when I placed the trade). Around this time the money flow index was also indicating the stock was overbought.
Again, I was lucky in my timing. I waited patiently for ERJ to fall to its established support level of ~$19.50 and rebuilt the position. The stock traded sideways until late December, when ERJ and Boeing confirmed they were engaged in merger talks. I will not bore you with the details but I felt there was a high probability the talks would end with no deal or at best some kind of joint venture agreement due to a veto right held by the Brazilian government related to ERJ’s defense business. During this time, the prior resistance level of $24 turned into the new support level.
That makes intuitive sense. No chart pattern voodoo is required. Previously, $24/share had been on the high end of fundamental investors’ estimates of the stock’s value. Now that ERJ’s fundamentals had inflected positively, it would make sense for that price to become the low end of a new range.
A couple of weeks after the original announcement a news story broke that Boeing had offered $28/share for a full takeover. $28 happened to lie smack in the middle of my $25-$30 valuation range. This was a critical piece of information because it implied the risk/reward tradeoff had deteriorated significantly. There was probably 1:1 upside to downside in the position at best. I trimmed heavily at a little over $26 and still hold a small position. If a deal gets done I will make a little more money on the takeout. If a deal doesn’t get done I will have an opportunity to rebuild the position at a lower level having gained additional conviction in my fundamental investment thesis.
Takeaways
This case study illustrates my view of active trading: it is a tool for managing the risk/reward tradeoffs embedded in a portfolio. Personally, I want to overweight positions when the risk/reward tradeoff is good and underweight them when it deteriorates. What I do not want to do is make binary decisions (e.g. choosing between “fully invested” and “100% cash”). In my opinion, there is too much randomness and uncertainty in the world and in markets to make blanket, binary calls about position sizing. See the chart below for a stylized example.
Source: Unknown (found via Google Image Search)
A good business will steadily compound its intrinsic value over time (red line). However, there are times when market price overshoots or undershoots intrinsic value (black line). In this way, having the ability to trade at the market price is kind of like owning an option struck at the intrinsic value per share. When a stock is overvalued the ability to trade functions like a put option (you can sell the stock for more than it is really worth). When a stock is undervalued the ability to trade is like a call option (you can buy the stock for less than it is really worth). The cost of the option is your transaction costs (commissions, bid-ask spread, taxes).
Put more simply: active trading allows you to overweight risk when you are getting paid well for taking it and to underweight risk when markets get stingy. However, using this approach, it is absolutely critical to have a high confidence estimate of intrinsic value. Otherwise you risk burning up capital as you chase the price around, getting whipsawed by reversals as you go.
Given how many smart people end up working in investment management, I am always surprised how siloed we can be. You tend to be a fundamental guy, OR a quant gal, OR a technician. Never all three. In my view there ought to be more interdisciplinary investment strategies. One reason there aren’t more of them is that capital allocators have a hard time underwriting strategies that don’t fit neatly into pre-established boxes (a subject for another post).
Personally, I don’t believe our world breaks down into neat little boxes, so I am interested in opportunities to integrate analytical techniques from different disciplines. To that end I have been studying up on how you might marry fundamental and technical analysis in a disciplined way. Typically a vast chasm of prejudice separates the two camps.
Fundamental Analyst:“Intrinsic value is what matters. Market price fluctuations are just noise to be ignored. Analyzing charts is like tossing chicken bones and reading the entrails of livestock to see the future. It is like trading based on ancient superstition.”
Technician:“Market prices are what matter. Market prices reflect supply and demand dynamics, as well as investor psychology. Prices are real and tangible, unlike some academic’s estimate of intrinsic value, which depends on “squishy” estimates of growth rates and discount rates.”
What we have here are two people talking across each other. It is like two people arguing over whether hammers or screwdrivers are “better” tools. In reality hammers and screwdrivers are different tools with different use cases.
I don’t believe technical analysis is particularly useful over long time horizons. There is plenty of evidence that in the long run, stock prices track earnings and dividend growth. I also don’t believe fundamental analysis is particularly useful over short time periods. If you are placing a trade, it is supply and demand that impact your execution, not market price relative to intrinsic value.
Fundamental analysis is going to give you a better idea of whether a business will be a good investment for the next decade. Technical analysis is going to give you a better idea of why today’s price is moving up or down.
Now, I should be up front about the fact that I am not at all interested in chart patterns. I have no interest in scouring candlestick charts for head-and-shoulders or cups-and-handles or van-gogh’s-remaining-ear. As far as I’m concerned that really is like tossing chicken bones or reading animal entrails. I prefer to use simple technical indicators to get a sense of price momentum and investor psychology.
For the time being at least I have focused on three indicators:
Support/Resistance Lines: You can draw a support line across the lows on a chart and a resistance line across the highs. In my view (I certainly don’t claim to be an authority on technical analysis), these lines are rough indications of where valuation sensitive investors have acted to counter a stock’s momentum. The support line forms where valuation sensitive investors step in to buy the stock. The resistance line forms where they sell the stock.
Moving Averages: Moving averages quantify short-term price trends versus long-term price trends and are useful for visualizing momentum. It is generally a bullish sign when a shorter-term moving average crosses above a longer-term moving average and a bearish sign when a shorter-term moving average crosses below a longer-term moving average.
Money Flow Index: The money flow index is an indicator tracking volume-weighted price momentum. It is an oscillator that moves between a range of values. It is useful for understanding whether price momentum is overextended in either direction, and whether it might soon reverse. More on the calculation and interpretation of money flow index here.
I think of the support/resistance lines as marking out the upper and lower bounds for the market’s estimate of a stock’s intrinsic value. Fundamental investors enforce these boundaries by trading contra-momentum (they sell when they believe a stock is overvalued and buy when they believe a stock is undervalued). Inside those boundaries, a stock will tend to ping-pong back and forth until the fundamentals change unexpectedly or fundamental investors significantly alter their expectations. A variation on the latter is when the type of investor dominating a stock’s investor base transitions from value to growth investors or vice versa.
Thus, I would argue, if you are an investor with a high degree of confidence in your estimate of a stock’s intrinsic value, and that estimate differs significantly from market expectations, you may be able to profitably trade around momentum-driven price swings–the goal being to generate higher position-level IRRs than you would earn by simply buying and holding.
In a follow on post I will walk through a live case study from my own portfolio to make this more concrete.
One of Ireland’s richest entrepreneurs has embraced an aggressive new version of an already esoteric form of junk bond, highlighting the level of risk that debt investors are willing to tolerate as they seek higher yields in hot credit markets.
The $350m “super PIK,” or payment-in-kind bond, raised at the end of last week will pay a dividend to a group of shareholders in Ardagh Group, a one-time small Irish glass bottle maker that has grown in the past two decades into one of the world’s largest metal and glass packaging companies.
PIK refers to bonds or loans that can pay their interest with further debt rather than cash. This means the size of the debt can balloon quickly and leave lenders with steep losses if the underlying company is not able to handle the growing burden.
No, your eyes do not deceive you. The company raised a $350mn bond issue that gives it the option of paying coupons with IOUs instead of cash. So it can pay insiders a dividend.
While Ardagh listed on the New York Stock Exchange last year, 92 per cent of its shares are held privately, with its billionaire founder and chairman Paul Coulson the largest shareholder. It is these private shareholders that are receiving the dividend. “In plain terms, the use of proceeds is essentially providing a ‘margin loan’ to legacy shareholders,” noted analysts at credit research firm CreditSights.
Here is the cap structure, if you are interested in a quick round of Spot The Suckaz:
Source: FT
And where exactly did this boondoggle price?
Despite its risky structure, the PIK bond sale drew roughly $2.5bn of orders, said a person close to the deal. This allowed it to ultimately price with a yield of 8.75 per cent, below the 10 per cent initially marketed. An older PIK dollar-denominated deal sold by the company in 2017 currently trades with a yield of 6 per cent.
Yeah, I know, it’s all anecdotal evidence. You can’t time the market or the credit cycle. Blah, blah, blah. Nonetheless, I vaguely recall an old Warren Buffett saw… something about when to be fearful and when to be greedy…
In recent posts (here and here) I explored my view that today’s markets are systematically mispricing risk. My analysis isn’t exactly rocket science. So why does this mispricing persist? Why does everyone shrug their shoulders and say, “well, there is no alternative,” versus simply dialing back their exposures or hedging out some of the tail risk? At the very least, investors could increase the discount rates used in their valuations to correct for ultra-low riskfree interest rates and build in a greater margin of safety.
So why don’t they?
I would argue that more than anything, it is business and political pressures that drive this behavior. Importantly, I don’t believe this mispricing of risk is irrational. Rather, I believe decisions that seem rational on a micro level have led to irrational behavior in the aggregate. Investors are simply behaving how they are incentivized to behave–as a herd.
Here are my reasons:
Institutional investors must remain invested. If you are a mutual fund manager or a hedge fund manager or venture capitalist, good luck explaining to your investors why you are sitting on a portfolio that is 40% cash. Many investors are loathe to stick with a manager who sits on a cash hoard for an extended period. Particularly in a buoyant market where cash will drag on returns. There is a sound rationale for this: the investor is perfectly capable of allocating to cash or hedging market risk on his own. Why pay some asset manager fees to sit on cash? While this makes plenty of sense from a business perspective, it makes no sense at all to an investing purist. The purist takes risk when the market is rewarding her for it and pares risk when the market is not rewarding her for it. Portfolios should be positioned more aggressively when markets are dislocated and prices are bombed out. They should be positioned more conservatively when valuations are high and expected returns are low.
Institutional investors are afraid to look different from their peers. Career risk drives a great deal of behavior in financial markets. It is the reason so many mutual funds look so similar to their benchmarks. This positioning makes no sense to a purist concerned with absolute returns. Yet it is perfectly rational for the mutual fund manager who will be fired if he drops into the fourth quartile of performance for a trailing 3-year period. Likewise for pension funds and endowments with trustees who may be penalized politically for contrarian positioning.
All investors have return hurdles to meet. If you are an individual or pension fund there is a certain rate of return that will allow you to fund your projected future liabilities. If you are an endowment or foundation there is some spending rule governing portfolio withdrawals, usually based on long-run capital market expectations. Altering these hurdles is a big deal. Reducing expected returns means pensions and individuals will have to save more to fund future liabilities. Endowments and foundations may have to cut financial support for certain programs. This can be psychologically devastating for individuals and extremely embarrassing for institutions. It is a powerful incentive for investors to take a “glass half full” view of the future, even if it is ultimately self-deluding and counterproductive.
Perhaps the most significant advantage you can get in the markets is what Ben Carlson calls organizational alpha. Put simply, this is the flexibility to do what others can’t, or won’t, as a result of business and political pressure. It is the freedom to switch off the autopilot and deviate from the pre-established flight plan.
