Wunderwaffen, Part II

My last post was about tradeoffs we must weigh when building investment portfolios. There’s no such thing as a magical asset. Most of the time we spend looking for superweapons (Wunderwaffen) is wasted. In this post I want to riff on Wunderwaffen from another angle: our fascination with things that are exciting conceptually but prove ineffective or even dangerous in practice.

This is a Messerschmitt Me-163 “Komet”.

The Komet was a rocket-powered interceptor designed to combat Allied bombers over Germany. Its distinguishing feature was its incredible speed–it could climb to combat altitude in just three minutes. One test pilot hit a speed of 700 mph in 1944. This set an unofficial world record that wasn’t broken until 1947, when Chuck Yeager set another unofficial record during a secret test flight. Officially, the flight airspeed record remained below 700 mph until 1953.

Unfortunately, the Komet’s incredible engine power was also the source of its greatest weakness. The volatile fuel mixture that fed the engine made it the rough equivalent of a flying bomb. The wiki on the Komet provides these details:

The fuel system was particularly troublesome, as leaks incurred during hard landings easily caused fires and explosions. Metal fuel lines and fittings, which failed in unpredictable ways, were used as this was the best technology available. Both fuel and oxidizer were toxic and required extreme care when loading in the aircraft, yet there were occasions when Komets exploded on the tarmac from the propellants’ hypergolic nature. […]

The corrosive nature of the liquids, especially for the T-Stoff oxidizer, required special protective gear for the pilots. To help prevent explosions, the engine and the propellant storage and delivery systems were frequently and thoroughly hosed down and flushed with water run through the propellant tanks and the rocket engine’s propellant systems before and after flights, to clean out any remnants. The relative “closeness” to the pilot of some 120 litres (31.7 US gal) of the chemically active T-Stoff oxidizer, split between two auxiliary oxidizer tanks of equal volume to either side within the lower flanks of the cockpit area—besides the main oxidizer tank of some 1,040 litre (275 US gal) volume just behind the cockpit’s rear wall, could present a serious or even fatal hazard to a pilot in a fuel-caused mishap.

Ultimately, the Komet had no impact on the European air war. It made very few kills and to the extent it did, its kill ratio was low. This disappointing operational performance hardly justified the many pilot deaths that occurred in development, testing and training.

There are lots of Komet-like investment products out there, including:

Levered and inverse levered ETFs
VIX Futures ETPs
Naked option writing strategies

Most of us shouldn’t get anywhere near these products and strategies. I’ll make an allowance for my trader friends who have a deep and intuitive grasp of the market forces that shape changes in both realized and implied volatility. For us tourists, the leverage and short gamma exposure embedded in many of these products are every bit as dangerous as the Komet’s rocket fuel.

Here’s what an engine fire looks like for these strategies:

201812_HFXAX_Chart — Source: Morningstar

So why are we drawn to this stuff?

Mostly because it’s cool. It’s got Sophistication! It gives us an excuse to talk about things like the volatility risk premium. It makes us feel as if we’re part of some elite fraternity of financial markets people. We “get it.” “Have fun with your index funds, you buy-and-hold simpletons.”

Except really, the joke is on us.

We should never underestimate our deep-rooted weakness for Sophistication! Most of us got into this business at least partly because we’re smart and competitive. We’re captivated by that powerful rocket engine as a feat of human ingenuity. Deep down, we want a shot at that airspeed record.

But it’s not necessarily the most powerful, most sophisticated engine that’s going to win us the war. It might not even make a difference.

And if we’re not careful, it’ll blow up on us.

01/08/19 Addendum: Got into a Twitter discussion on this topic and Corey Hoffstein of Newfound Research was kind enough to educate me on how inverse and leveraged ETFs can be used in a DIY risk parity implementation for small investors. Here is the link to his article. So as always, it seems, #notall applies.

Wunderwaffen

One theme I harp on relentlessly is that there’s no such thing as a magical investment strategy. By “magical strategy” I mean some asset class or system that’s inherently superior to all others. Hedge funds were once sold this way, and we’ve spent the last 10 years or so watching the ridiculous mythology built up around hedge funds die a slow and miserable death.

The unpleasant truth is that all investment strategies involve tradeoffs. In this way, investment strategies are a bit like weapons systems.

Tank design, for example, must balance three fundamental factors:

Firepower
Protection
Mobility

This is a Tiger tank:

Bundesarchiv_Bild_101I-299-1805-16,_Nordfrankreich,_Panzer_VI_(Tiger_I).2 — Source: Bundesarchiv via Wikipedia

You might recognize it from any number of WWII movies and video games. The Tiger is often presented as a kind of superweapon (German: Wunderwaffe)–an awe inspiring feat of German engineering. In many respects, the Tiger was indeed a fearsome weapons system. Its heavy frontal armor rendered it nearly invulnerable to threats approaching head-on. Its gun could knock out an American M4 at distance of over a mile, and a Soviet T-34 at a little under a mile.

The Tiger had its weaknesses, however, and they were almost laughably mundane. It was over-engineered, expensive to produce and difficult to recover when damaged. Early models in particular struggled mightily with reliability. The Tiger was also a gas guzzler–problematic for a German panzer corps chronically short on fuel.

Viewed holistically, the Tiger was hardly a magical weapon. The balance of its strengths and weaknesses favored localized, defensive operations. Not the worst thing in the world for an army largely on the defensive when the Tiger arrived on the battlefield. But it was hardly going to alter the strategic calculus for Germany. In fact, there’s an argument to be made that German industry should have abandoned Tiger production to concentrate on churning out Panzer IV tanks and StuG III assault guns. (Thankfully, for all our sakes, it did not)

Likewise with investment strategies, the tradeoffs between certain fundamental factors must be weighed in determining which strategies to pursue:

Alpha Generation
Liquidity
Capacity

Alpha generation is typically inversely related to liquidity and capacity. The more liquid and higher capacity a strategy, the less likely it is to consistently deliver significant alpha. Smaller, less liquid strategies may be able to generate more alpha, but can’t support large asset bases. Investment allocations, like military doctrine, should be designed to suit the resources and capabilities at hand.

If I’m allocating capital, one of the first things I should do is evaluate my strategy in the context of these three factors.

First, do I even need to pursue alpha?

If so, am I willing and able to accept the liquidity constraints that may be necessary to generate that alpha?

If so, does my strategy for capturing alpha have enough capacity for an allocation to meaningfully impact my overall portfolio?

In many cases, the answer to all three of those questions should be a resounding “no.”

And that’s okay! Not everyone should be concerned with capturing alpha. For many of us, simply harvesting beta(s) through liquid, high-capacity strategies should get the job done over time. Identifying strategies and investment organizations capable of sustainable alpha generation ex ante is extremely difficult. And even if we can correctly identify those strategies and investment organizations, we must have enough faith to stick with them through the inevitable rough patches. These are not trivial challenges.

But even more importantly, in a diversified portfolio it’s unlikely you’ll deploy a single strategy so powerful and reliable, and in such size, that it completely alters your strategic calculus. In general, we ought to spend more time reflecting on the strategic tradeoffs facing our portfolios, and less time scouring the earth for Wunderwaffen.

You Can’t Borrow Conviction

palumbo_callahan_barlow — Source: David Palumbo

“Nowhere left to go,” Barlow murmured sadly. His dark eyes bubbled with infernal mirth. “Sad to see a man’s faith fail. Ah, well…”

The cross trembled in Callahan’s hands and suddenly the last of its light vanished. It was only a piece of plaster that his mother had bought in a Dublin souvenir shop, probably at a scalper’s price. The power it had sent ramming up his arm, enough power to smash down walls and shatter stone, was gone. The muscles remembered the thrumming but could not duplicate it.

[…] And the next sound would haunt him for the rest of his life: two dry snaps as Barlow broke the arms of the cross, and a meaningless thump as he threw it on the floor.

[…] “It’s too late for such melodrama,” Barlow said from the darkness. His voice was almost sorrowful. “There is no need of it. You have forgotten the doctrine of your own church, is it not so? The cross… the bread and wine… the confessional… only symbols. Without faith, the cross is only wood, the bread baked wheat, the wine sour grapes.”

–Stephen King, ‘Salem’s Lot

Whenever the market falls, you start to see symbol-waving. This famous Charlie Munger quote about equity drawdowns, for example:

If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder, and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.

This is core doctrine for the Church of Value Investing. It works for Charlie because Charlie has Faith. Unfortunately, many of us who wave the symbols of Buffett and Munger in the face of Scary Things do not, in fact, have Faith. We fancy ourselves members of the Church of Long-Term, Buy & Hold Investing when times are good. But when things go bump in the night, we find ourselves waving cheap plaster crosses at the drawdown monster.

barlow

And it works about as well for us as it did for Father Callahan.

So we make arbitrary changes to what are meant to be long-term asset allocations designed to capture structural risk premia. We fiddle with exotic alternative strategies we don’t properly understand. We sell to cash without any idea how we’ll convince ourselves to buy back in. We seriously damage our chances of achieving our long-term objectives.

This chart?

This chart is a plaster cross. I show it specifically because it’s the most common exhibit financial advisors use to harp on “a long-term view” in client presentations.

But if you don’t believe equities should earn a structural premium over gold or T-bills or credit over very long periods of time, this chart will do nothing whatsoever to help you when your equity holdings halve. Same if don’t believe your portfolio has enough of a liquidity buffer to withstand a lengthy drawdown. You will waver. The drawdown vampire will snap your plaster cross and eat you.*

How do you build Faith?

Honestly, I had only the vaguest idea how to answer that question, so I punched it into Google and found this article (no idea what The Living Church of God might be–link isn’t an endorsement). Suggestions include:

Prove what you believe (or try to, anyway).

Study what you believe.

Endure the trials that arise as you go.

Because ultimately, there are no shortcuts to Faith.

Faith is a Process, not an Answer.

You can’t borrow conviction.

*Yeah, I know Barlow doesn’t actually kill Father Callahan in ‘Salem’s Lot. ‘Salem’s Lot purists can extend the metaphor and imagine the drawdown vampire turning them into unclean market-timers, doomed to wander the earth for all eternity with low returns and even less credibility.

“Could you put in some Mayans?”

480px-Harlan_Ellison_at_the_LA_Press_Club_19860712 — Source: Wikipedia

Harlan Ellison died this year. A terrible loss.

He was one of the better science fiction writers of all time. Thinking about “I Have No Mouth, And I Must Scream” still gives me the jibblies. Ellison was no shrinking violet when it came to the business side of his chosen art form. He was also famously protective of his artistic integrity.

In fact, he might written the original Star Trek movie, if only he were a bit more flexible. Stephen King recounts the story in his (underrated) book, Danse Macabre. In a lengthy footnote, he gives Ellison’s version of events:

Paramount had been trying to get a Star Trek film in work for some time. [Gene] Roddenberry was determined that his name would be on the writing credits somehow… The trouble is, he can’t write for sour owl poop. His one idea, done six or seven times in the series and again in the feature film, is that the crew of the Enterprise goes into deepest space, finds God, and God turns out to be insane, or a child, or both. I’d been called in twice, prior to 1975, to discuss the story. Other writers had also been milked. Paramount couldn’t make up their minds and had even kicked Gene off the project a few times, until he brought in lawyers. Then the palace guard changed again at Paramount and Diller and Eisner came over from ABC and brought a cadre of their… buddies. One of them was an ex-set designer… named Mark Trabulus.

Roddenberry suggested me as the scenarist for the film with this Trabulus, the latest… of the know-nothing duds Paramount had assigned to the troublesome project. I had a talk with Gene… about a storyline. He told me they kept wanting bigger and better stories and no matter what he suggested, it wasn’t big enough. I devised a storyline and Gene liked it, and set up a meeting with Trabulus for 11 December (1975). That meeting was canceled… but we finally got together on 15 December. It was just Gene and Trabulus and me in Gene’s office on the Paramount lot.

I told them the story. It involved going to the end of the known universe to slip back through time to the Pleistocene period when Man first emerged. I postulated a parallel development of reptile life that might have developed into the dominant species on Earth had not mammals prevailed. I postulated an alien intelligence from a far galaxy where the snake had become the dominant life form, and a snake-creature who had come to Earth in the Star Trek future, had seen its ancestors wiped out, and who had gone back into the far past of Earth to set up distortions in the time-flow so the reptiles could beat the humans. The Enterprise goes back to set time right, finds the snake-alien, and the human crew is confronted with the moral dilemma of whether it had the right to wipe out an entire life form just to insure its own territorial imperative in our present and future. The story, in short, spanned all of time and all of space, with a moral and ethical problem.

Trabulus listed to all this and sat silently for a few minutes. Then he said, “You know, I was reading this book by a guy named Von Daniken and he proved the Mayan calendar was exactly like ours, so it must have come from aliens. Could you put in some Mayans?”

Is there not a more perfect parallel for client meetings?

You spend hours, if not days or weeks, agonizing over the minutiae of asset allocation and return expectations and manager changes and security selection only for the client to turn around and ask for some Mayans.

“I hear weed is going to be huge. Can we buy some pot stocks?”

Or:

“I found a company that wants to build a bridge to Mars. They’re crowdsourcing investors. Can I invest?”

Unfortunately, we can’t respond the way we’d like to respond in our darker moments–how Harlan Ellison responded to Mark Trabulus during their fateful meeting in 1975:

I looked at Trabulus and said, “There weren’t any Mayans at the dawn of time.” And he said, “Well, who’s to know the difference?” And I said, “I’m to know the difference. It’s a dumb suggestion.” So Trabulus got very uptight and said he liked Mayans a lot and why didn’t I do it if I wanted to write this picture. So I said, “I’m a writer, I don’t know what the fuck you are!” And I got up and walked out. And that was the end of my association with the Star Trek movie.

There are a lot of reasons clients ask for Mayans for their portfolios. Greed. Fear of missing out. We learned all that in Behavioral Finance 101. But there’s another reason clients ask for Mayans. It’s the same reason Mark Trabulus asked for Mayans back in 1975, while sitting there in the long shadow of Harlan Ellison, the creative genius.

They want to contribute.

Imagine yourself on the client side of the table. You sit in meeting after meeting going over dreary reports full of inscrutable data tables. You’re bombarded with jargon. You scan your portfolio and it’s full of abstracted stuff like foreign SMID cap value funds.

Can we really blame people for wanting to contribute some of their own ideas? It’s their money in the portfolios, after all.

Yes, their ideas are usually bad ideas. You can’t let them run roughshod all over the place. There’s a reason they’ve hired a professional for advice. But it’s just as important to recognize some of the most annoying things clients say and do don’t necessarily come from a place of fear or greed or arrogance.

This is why I am generally a fan of “play money” accounts for individuals. Some side pocket of the portfolio over which the client has complete discretion, but that’s sized so it won’t blow up the financial plan if it goes to zero. Not everyone wants a play account, or needs one. But for clients who do, it’s an important outlet.

It’s a way for them to participate in the financial markets and the investment process.

It’s a way for them to express… (dare I say it?)… some creativity.

Even if their ideas are dumb.

A World Of “Meh”

Right now, a lot of people are sitting out there trying to decide whether to dip-buy this market. They want to tick the bottom. Perhaps you are one of these people. In my own humble opinion, they are fools–fools engaged in a foolish game. Most will ultimately do more harm to their net worth than good, whipsawing themselves based on “sentiment” (a.k.a what they are seeing and hearing from the financial media).

For some perspective, I want to revisit forward-looking return expectations from a couple of different sources.

The chart below looks at prospective 10-year S&P 500 returns as a function of the equity share of US financial assets (a mouthful, I know). This is similar to the Buffett Indicator of stock market capitalization/GDP. The data runs through 3Q18, which is the most recent Z1 release from the Federa l Reserve.

(As far as I know, Jesse Livermore at Philosophical Economics was the first to do a deep dive into the efficacy of this model. David Merkel at Aleph Blog used to update it quarterly. Since David seems to have abandoned the project, I’ve decided to pick this up on my own)

SP_500_Proj_Return — Data Sources: Federal Reserve, Morningtsar

The predicted forward return bottomed in 1Q18, below 5% nominal. Since then, the proportion of equities to total assets has decreased a few points. This corresponds to a modest increase in predicted return over the next 10 years, to approximately 7%.

The second chart is an updated expected return bar chart from Research Affiliates:

201812_RAFI_10YR_ERs — Source: Research Affiliates

RAFI’s methodology is the simple model discussed in my post on investment return expectations. RAFI’s estimates are even less inspiring than the equity allocation model. Here US Large Cap is expected to return about 2.7% nominal over the next 10 years.

If we weight each forecast 50/50 to account for the inevitable errors and uncertainty, we get something like 4.8% as an expected return for US Large Cap Stocks over the next 10 years.

To which I say: “meh.”

This is neither a “run for the hills” number nor a “go all-in” number for someone whose investment strategy is oriented around asset allocation over a long time horizon. In fact, it’s rare to arrive at either of those conclusions from an exercise like this. Which is the whole point. For most of us, our reaction to most market moves should be “meh.”

Now, this certainly isn’t the only lens through which you can view financial markets. A trader or trend follower can safely ignore everything I’ve written here. Traders and trend followers are playing an entirely different game. Same for pure, bottom-up stock pickers.

However, most of us building portfolios for institutions and individuals are not traders, trend followers or pure, bottom-up stock pickers. We’re asset allocators who merely need to be directionally correct about the performance of a handful of different asset classes over a couple of decades.

How does a fundamentally-oriented allocator invest in a world of “meh?”

I’d suggest the following core principles:

Balance. Never make “all-in” or “all-out” calls. Investing is an exercise in decision-making under uncertainty. It’s a probabilistic exercise, except we don’t know the “true” probabilities of the various outcomes. Only fools make all-in, all-out calls when making decisions under uncertainty. And yes, gunslinging hedge fund guys, fools who make all-in, all-out calls can become billionaires.

Prudence. Don’t reach for yield or return. Our world is overrun with yield pigs, but they’re generally not being well-compensated for the incremental risks they’re running to juice their returns. And yes, middle market private credit investors, that’s directed at you.

Flexibility. As Henri Poincaré famously said, “geometry is not true, it is advantageous.” Asset allocation is similar. You become overly attached to particular asset classes, strategies and their historical performance at your peril. And yes, “VOO for the long run” investors, that’s directed at you.

Creativity. If the financial markets are giving you “meh”, consider changing the way you play the game. For individuals, that could mean saving more, or starting a business to generate wealth through “real world” economic activity. For institutions, it’s tougher to make those kinds of changes, but mostly for political reasons.

It is a frustrating thing, to be stuck in a word of “meh.” But recognizing it and acting accordingly is a hell of a lot more productive than staring at your E-Trade account trying to tick the bottom for SPY.

Storytime

Ricky Roma: I’m going to tell you something. Your life is your own. You have a contract with your wife? You have certain things you do jointly? Bond there. And there are other things, and those things are yours. And you needn’t feel ashamed, you needn’t feel that you’re being untrue. Or that *she* would abandon you if she knew. This is *your* life.

—Glengarry Glen Ross

Ricky Roma is the best salesman in the office. He’s at the top of the Cadillac board. And that’s no accident. Ricky Roma is a masterful storyteller. He knows all about needful things.

Ricky Roma’s stories appeal to us on an emotional level. But there are other, equally effective storytellers out there appealing to us on an intellectual level.

Much of what we think of as “financial analysis” is this second type of storytelling. Finance people tend to look down on writers and artists, but I can assure you there’s no less creativity involved in financial analysis. If you’ve ever built a discounted cash flow model, or an LBO model, you’re well aware of the enormous number of assumptions embedded in the things. Choosing a discount rate isn’t so different from a painter mixing colors on her palette.

Granted, that’s a fairly subtle example. Storytelling masquerading as analysis is much more obvious (not to mention silly) in the context of “portfolio update” and “strategy” meetings.

These are the meetings where a PM or strategist sits down with a slide deck and tells you about the state of a portfolio or the world. Make no mistake. There’s nothing analytical or scientific about this process. It’s theatre. The slide deck and the charts are just props to be used in the performance.

If the PM or strategist is a value guy, the story will be about mean reversion.

If the PM or strategist is a trend guy, the story will be about momentum.

The odds you’ll derive any decision-useful information from a performance like this are slim. To the extent there’s decision-useful information embedded in the performance, it’s in the metatext—the story of the story.

For example, there isn’t decision-useful insight embedded in a CE webinar about how floating rate securities have performed historically in rising rate environments. This is what I’d call a bagholder webinar. Same with sell-side research.

You don’t derive decision-useful insight from naively sitting through bagholder webinars and naively reading bagholder-oriented research. Do you honestly believe these firms produce research out of a deep, unwavering commitment to the Search For Truth?

No. Research groups are cost centers. They produce reports and exhibits in support of their salespeople. So always ask yourself: “why am I seeing this NOW?”

The first-order answer is usually that someone’s trying to sell you something. That firm hosting the CE webinar knows you know we’re in a rising rate environment. They know you’re worried about what it means for fixed income portfolios. Oh, look, they just happen to run a floating rate fund.

This may be a useful insight. But it’s also a trivial insight. Just because someone’s selling you something doesn’t mean it’s a bad deal.

More valuable insight comes from understanding the issuers of floating rate paper (via the sell-side) also know the firm running the floating rate strategy knows you’re worried about what rising rates mean for fixed income portfolios.

Put another way, what you need to address in your analysis isn’t how the asset class has performed historically. You need to address how the asset class might perform based on how deals are priced, structured and sold today.

Deal pricing is predominantly influenced by buy-side appetite for various types of securities. From there, it’s a matter of supply and demand.

The stories told by PMs and strategists and the sell-side and everyone else in the market ecosystem are told to influence our appetites for different cash flow profiles.

It’s storytelling that drives demand.

It’s storytelling that closes deals.

Remember this next time you’re parsing pro forma financial statements; or some chart illustrating the value/growth performance divergence; or a scatter plot showing how some asset class (*ahem* private equity) dominates everything else on a risk-adjusted basis.

It’s storytime.

The Best Risk Questionnaire (Bonus: It’s Free!)

Answer the following questions with complete honesty:

Did I buy equities in October and/or November of 2018?
If so, what did I buy?
Why?

This exercise will give you a pretty good idea of how you handle market volatility. Not in a theoretical, highly-abstracted, mean-variance optimized way but in the visceral OH-MY-F*ING-GOD-this-stock-I-own-just-fell-40%-WTF-do-I-do-now?!?!? kind of way.

In other words, this exercise gets you thinking about risk in the only terms that matter.

Many people have told me, “oh when the market goes down stocks are on sale so I buy. Buffett says to be greedy when others are fearful.”

Most of them are liars.

People overstate their risk tolerance in bull markets. Ask the crypto people how much time they spent thinking about risk last December. Ask the FANG cheerleading section how much time it spent thinking about risk in 1Q18. I bet if you’d given these investors risk questionnaires they would’ve come back showing an extreme willingness to take financial risk. Everyone feels like Warren Buffett when the tape is printing big, fat green numbers day after day.

In the financial advice business we like to pretend we can put neat little numbers around people’s risk tolerance. We give them risk questionnaires or gussied-up, Millennial-friendly versions of risk questionnaires to match them with a model portfolio that ultimately ends up being the usual 80/20 or 60/40 or 70/30 mix you’d give someone just from eyeballing her age. Maybe we go 50/50 if she seems particularly elderly and infirm.

All of this is nonsense. It is scientism.

The way you measure someone’s true risk tolerance is to look at how they’ve allocated real dollars of their hard-earned cash. If a prospect shows up in your office with $500,000 in a bank savings account and no equity investments whatsoever, you’re dealing with someone who doesn’t like taking risk. If someone shows up with $1,000,000 of a $2,000,000 portfolio in small cap biotech stocks and another $500,000 in rental properties with a bunch of debt on them you know you’ve got a gunslinger on your hands.

Simple. Easy. Robust.

Yes, guy in the back, I can hear you muttering something under your breath about “investor education.” “Some of those people with $500k sitting at the bank just don’t understand investing and that’s why they sit in cash.” So what? Their willful ignorance further underscores their risk aversion.

People who are extremely tolerant of financial risk seek out risk on their own initiative. In business we call these people “entrepreneurs.” They may sometimes take risk in stupid ways, by reading scammy stock newsletters or buying a bunch of Litecoin or whatever, but their propensity for risk taking clearly manifests itself in their portfolios.

To steal blatantly from Taleb, this is a “skin in the game” thing.

Ignore what people say.

Pay close attention to what they do.

Reaching For Yield

Are you a high net worth individual investor?

Are you feeling left out of the institutional yield chase?

Do you wish you could access the same esoteric, illiquid credits as pension funds and endowments?

If so, we may just have an investment opportunity for you.

Interval funds offer you, the high net worth individual, the full institutional investing experience. Not only do you get the high management fees and carried interest associated with traditional private equity investments, but as an added bonus you will invest through a seemingly liquid, mutual-fund like structure that is in fact subject to the vagaries of market conditions and the fund sponsor’s judgement.

That’s basically the pitch for interval funds. Interval funds are part of a larger growth trend for private credit and direct lending funds. Remember all the risky loans banks used to make prior to the financial crisis? Well, banks don’t make those loans anymore. They have regulation to thank for that. The risky loans didn’t go away, though. They just moved from bank balance sheets to private credit vehicles–unregulated hedge fund and private equity-like structures.

Up until recently private credit has remained out of reach of most individual investors. Interval funds are now being marketed as a way for a wider array of individuals to access private credit and even private equity. The idea is that a sponsor with expertise in these areas (like Carlyle) can sub-advise on a strategy that can be sold through a large asset manager with established retail distribution channels (like Oppenheimer Funds).

As you might guess I have several issues with interval funds. Here are the main ones:

You have know way of knowing whether the sponsor actually cares about performance or is just dropping mediocre deals into the structure to gather assets in a high fee product. I struggle to believe these sponsors are saving their choice deals for interval funds when they have longtime relationships with large, institutional investors to look after.
Illiquid things are being held in what is being marketed as an open-ended structure. This works right up until it doesn’t. In the event of a severe market dislocation these funds will suspend their repurchase programs and investors will be stuck.
In my view, you’re not being compensated particularly well for the risks you’re taking. Don’t take my word for it. Read the financials. Maybe you think 500-ish bps of spread is fair compensation for this kind of risk. Fair enough. But consider that JNK will give you nearly 400 bps of spread over 10-year Treasuries these days.

Here’s what the portfolio valuation disclosure for the Carlyle/Oppenheimer vehicle I’ve been linking to above looks like:

OPCIX_ASC_820 — Source: OFI Carlyle Private Credit Fund Semi-Annual Report

This would be pretty typical for a private fund playing in credit such as a credit hedge fund. I have a mental rule of thumb for these things which goes like this: in a dislocated market, assume the fund will turn completely illiquid. Do not invest unless you’re prepared to live with the consequences.

The sales pitch for interval funds is straightforward. It’s yield!

There’s a pejorative term in the business for investors who chase yield without regard to risk. We call them yield pigs. And yield pigs almost always end up getting slaughtered.

Time to go long Bitcoin?

It’s fashionable these days to dunk on Bitcoin and cryptocurrency more generally. Charts like the one below lend themselves to dunking. And I must confess some schadenfreude as certain crypto shills and charlatans get some well-deserved comeuppance.

181130_BTC_1YR_Chart — Source: WorldCoinIndex.com

I’ve written about crypto on several occasions on this blog. While I’ve enjoyed following the space from a distance, I’ve never put real dollars on the line. As I wrote last year in my Bubble Logic post, I just can’t get my head around how to judge when the stuff is cheap or expensive.

Are cryptocurrencies actually worth anything? If so, what are they worth?

I took a stab at this myself not too long ago. It was a useful exercise although it did not exactly end with concrete results. So despite having learned even more about blockchain and cryptocurrencies in the meantime, I remain stuck.

How am I supposed to invest in something that I cannot value?

Now, there is a pragmatic solution I have not really discussed (also mentioned by one of Patrick’s interviewees). That is, you can simply look at cryptocurrencies as call options (or, if you prefer less financial jargon, as lottery tickets). Viewed through the lens of portfolio construction this is far and away the best way of approaching the problem given the dramatic skew in the distribution of potential returns. Max downside is 100% of the original investment. And max upside is what? A 1000x gain? More? That is a pretty attractive option.

Yet it still doesn’t sit right with me. It feels too much like gambling. Which isn’t the worst thing in the world. I enjoy the occasional trip to the casino. However, conflating investing and gambling does not seem like a real answer. In fact it seems like bubble logic: gamble a little so you won’t miss out and regret it.

I wrestle with the same dilemma today.

On the one hand, the narrative around crypto has definitely shifted. It’s gotten extremely negative. I’d say it’s bordering on capitulation. If valuing this stuff were as straightforward as valuing stocks, it would be time to go bargain hunting.

Unfortunately, valuing crypto is not as straightforward as valuing stocks. You don’t have cash flows to look at. You don’t have hard assets to look at. All you’ve got is supply and demand.

For what it’s worth, I don’t believe Bitcoin is a zero. Bitcoin is ultimately a faith-based asset. It has value to the extent other people believe it has value. There’s probably always going to be at least some subset of the population that believes Bitcoin has value. But as a potential investor, I have to suss out whether the size and enthusiasm of that faith community translate to a price of $0.001, $1,000,0000, or something else entirely. Then I have to assign probabilities to those outcomes. That’s simply not something I’m able to do with any real confidence.

That said, I’m not ready to write all crypto off as an investment fad or fraud.

I’m interested in applications for distributed ledgers that aren’t built on a narrative of “get rich or die tryin’.”

I’m interested in crypto (and Bitcoin specifically) as a potential financial hedge against kleptocracy and economic mismanagement (China, Zimbabwe, Venezuela).

I’m interested in crypto’s potential to democratize and decentralize the issuance and trading of securities that can be valued using traditional means.

I do think crypto is here to stay, in some form or fashion. But I’m still not prepared to make financial bets on those outcomes.

Mad Scientist Futurists

“Any sufficiently advanced technology is indistinguishable from magic.” –Arthur C. Clarke.

In my line of work, I sit in a lot of meetings. I listen to a lot of conference calls. I attend a lot of conferences. Many of these are thinly disguised sales presentations. Sure, we don’t call them sales presentations. We call them “continuing education” or “maintenance due diligence” or “onsite manager visits.”

You sit through enough of these meetings and you begin to recognize different archetypes.

There’s The Brilliant Introvert.

The Streetwise Deal Guy.

The Mad Scientist Futurist.

That last fellow is most often encountered in group settings. Particularly conferences. I’d venture to say the industry conference is the Mad Scientist Futurist’s natural habitat.

Now, the guy doesn’t necessarily predict the future. He might merely describe a possible future. These days, for example, the future seems to involve a lot of e-sports and e-commerce and machine learning. A few years ago it was drones and 3D printers as far as the eye could see.

The Mad Scientist Futurist spends a lot of time on his description of the future. And it’s not just him up there talking, mind you. He’s got sales collateral. He’s got data and charts and renderings. He does Science!, remember? After about fifty slides of this, it all takes on a certain aura of inevitability.

And then, finally, once he’s painted a sufficiently fantastical image of the future, the Mad Scientist Futurist tells you what the future means.

He tells you what it means for society. He tells you what it means for the economy. He tells you what it means for your portfolio.

The Mad Scientist Futurist is a modern incarnation of the wizard! meme. We seem hardwired to respond to wizards as symbols, both in stories and in life. Merlin is a wizard. Faust is a wizard. Elon Musk and Satoshi Nakamoto are wizards.

We have an innate weakness for wizards and Mad Scientist Futurists precisely because we’re hungry for meaning and Narrative. When we see ~~magic~~ advanced technology in action, our tiny minds can scarcely comprehend the implications. We want someone to walk us through them. We need someone to walk us through them.

This isn’t necessarily a bad thing.

But it can be dangerous.

Because memes and archetypes are so powerful, they’re easily weaponized to sell us stuff. The Mad Scientist Futurist is typically deployed to sell what the style box classifies as “growth” investments–expensive tech stocks and venture capital and such.

Now, there’s nothing inherently wrong with owning expensive tech stocks and venture capital and the like. But you should own it because you’ve made a conscious decision about the role it plays in your portfolio–not because a Mad Scientist Futurist cast a Buy! spell on you.