Unhelpful, Misguided, Amateurish

A reader responds to my MMT post:

[t]he above is a terrible unhelpful, misguided and amateurish review of MMT. Your understanding of the role of inflation and the actual operational positions espoused by its proponents is useless. Perhaps it’s driven by politics or some ideology but you could probably learn a bit by spending a bit more time on it all.

Fair enough.

Look. I’m not an economist. I write as a practitioner in financial markets. As such, I’m mainly concerned with incentive systems and how they impact strategic decision making by individuals and institutions.

Politicians are always and everywhere incentivized to run deficits and print money. Hand politicians a license to run deficits of arbitrary size and they will print and print and print. This isn’t left versus right political thing. This is a human nature thing.

Under MMT, it would be up to self-interested politicians and their appointed bureaucrats to ensure we don’t end up with hyperinflation. Self-interested politicians and appointed bureaucrats hardly have an unblemished track record when it comes to economic management.

Now, I should be clear here that my commenter is correct. My opposition to MMT is absolutely ideological. Specifically:

  • I don’t believe bureaucrats are capable of pulling off the operational balancing act MMT requires.
  • More importantly, I don’t believe bureaucrats ought to be empowered to try and pull off the operational balancing act MMT requires in the first place.

In my estimation, the downside risks are catastrophic. We could end up on The Road To Serfdom. We could end up with hyperinflation. Anyone regularly involved in decision making under uncertainty knows that the way you manage the risk of ruin is either to hedge it or to avoid taking it in the first place.

That’s not to say MMT can’t work. The theoretical viability of MMT is something for economists to argue over.

My argument is much, much simpler. Given what we know about human nature and fallibility, and given the historical track record of economic planners and administrators, the potential negative outcomes from a real-world implementation of MMT (you know, total economic collapse) far outweigh the potential benefits.

As a wiser man than me once said: “you were so preoccupied with whether you could, you didn’t stop to think whether you should.”

Portfolio Construction In A Frightening And Uncertain World

My last post on risk management was somewhat impractical. It was critical of the shortcuts we often take in analyzing risk but didn’t offer anything in the way of practical alternatives.

The theme of the last post was that in spite of the sophisticated-sounding calculations underlying most analyses, they are at best crude approximations. In general, these approximations (e.g. assumption of uncorrelated, normally distributed investment returns) make the world seem less risky than it really is.

So, what are we supposed to do about it?

In theory:

  • We should take even less risk than our statistical models indicate is acceptable, building in an extra margin of safety. For example, holding some cash reserves even if we have the risk tolerance to run fully invested.
  • We should use leverage sparingly.
  • We should not make overly concentrated bets. I’m not just talking about individual stocks here. The same goes for securitized asset classes like US large cap stocks.
  • We should not have too much conviction in any given position.

Also, in theory, the more certain you are of an investment outcome, the larger and more concentrated you should make your positions. If you knew the future with total certainty, you would go out and find the single highest return opportunity out there and lever it to the max.

Given we live in a world where a 60% hit rate is world class, most of our portfolios should be considerably more diversified with considerably less than max leverage.

I don’t think any of that’s particularly controversial.

But I’m not just talking about individual stocks here. This goes for broad asset classes and the notion of “stocks for the long run,” too. I’m not arguing we should all be capping equity exposure at 50%. But it’s prudent to stress portfolios with extreme downside scenarios (this is unpopular because it shows clients how vulnerable they are to severe, unexpected shocks).

How robust is the average retiree’s portfolio to a 30% equity drawdown that takes a decade to recover?

For that matter, how robust is the average retiree’s portfolio to 1970s-style stagflation?

Jason Zweig interviewed a couple of PMs who had to endure through that period:

“It was so painful,” says William M.B. Berger, chairman emeritus of the Berger Funds, “that I don’t even want my memory to bring it back.” Avon Products, the hot growth stock of 1972, tumbled from $140 a share to $18.50 by the end of 1974; Coca-Cola shares dropped from $149.75 to $44.50. “In that kind of scary market,” recalls Bill Grimsley of Investment Company of America, “there’s really no place to hide.” Sad but true: In 1974, 313 of the 318 growth funds then in existence lost money; fully 123 of them fell at least 30%.

“It was like a mudslide,” says Ralph Wanger of the Acorn Fund, which lost 23.7% in 1973 and 27.7% more in 1974. “Every day you came in, watched the market go down another percent, and went home.”

Chuck Royce took over Pennsylvania Mutual Fund in May 1973. That year, 48.5% of its value evaporated; in 1974 it lost another 46%. “For me, it was like the Great Depression,” recalls Royce with a shudder. “Everything we owned went down. It seemed as if the world was coming to an end.”

Are we building portfolios and investment processes taking the possibility of that kind of environment into account?

Are we equipped psychologically to deal with that kind of environment?

I conclude with this evocative little passage from George R.R. Martin:

“Oh, my sweet summer child,” Old Nan said quietly, “what do you know of fear? Fear is for the winter, my little lord, when the snows fall a hundred feet deep and the ice wind comes howling out of the north. Fear is for the long night, when the sun hides its face for years at a time, and little children are born and live and die all in darkness while the direwolves grow gaunt and hungry, and the white walkers move through the woods.”

Your Risk Analysis Sucks

Yesterday I was discussing some risk analysis with a colleague. Specifically, quantitative risk scores for fixed income funds. The details of the scoring are not important for the purposes of this post. Suffice it to say it is along the lines of sorting funds into quartiles based on statistics such as rolling volatility and drawdown.

The point of our discussion was that soon the financial crisis period will roll off the risk scores, penalizing more conservative portfolios in the ranking system. The scores will implicitly reward excessive risk-taking.

This is a great metaphor for the state of markets today.

Collectively, we have forgotten what it means to be afraid. Today, it is all about squeezing as much return as possible out of a portfolio. Fear has rolled off our collective memory. And what’s worse our lack of fear is justifiable according to the trailing 10-year data.

This at a time when:

  • Credit spreads are tight.
  • Covenants are weak.
  • Leverage is high.
  • Oh, and interest rates are rising.

There is an inherent tension in risk management between simple statistical measures (which people prefer) and the true nature of risk (which is nuanced and difficult to quantify). In fixed income in particular, the payoffs are negatively skewed. As an extreme example: “I have a 94% chance of earning a 6% yield on my $100 principal investment and a 6% chance of losing the $100 of principal.” Only in real life we don’t know the probability of default in advance.

The standard deviation of a high yield bond fund does not do a great job of describing its risk. In the absence of defaults the volatility will be fairly mild. If defaults tick up in a recession, losses could be catastrophic–particularly if liquidity dries up and twitchy investors decide to redeem en masse. None of the most significant risks to a high yield investment are properly captured by its standard deviation.

But people do not want to talk about conditional probability and expected losses given default and the uncomfortable fact that their financial lives are non-ergodic.

People want simple, black and white answers.

Statistical risk analysis is popular because it uses straightforward inputs and is easy to run at scale. Looking at a portfolio and puzzling out how it might behave in future states of the world, without relying on correlation and volatility statistics, takes a lot of time and energy. It is a “squishy” process. Your peers might think you are a bit of a crank because you aren’t sufficiently “data-driven.”

Oh, and much of the time things will run smoothly anyway.

Diligent risk management is a thankless task. No one pats you on the back for the things that didn’t go wrong. In fact, in a market environment like this one, a little extra prudence can get you fired.

This is why cycles happen. People forget that a little fear is healthy. Or, more precisely, the market environment conditions people to invest more aggressively. They overreach (their backward-looking risk analyses encourage it!) Then when the cycle rolls over they get slaughtered.

Whenever I am looking at an investment one of the things I think long and hard about is under what conditions it might explode spectacularly like a dying star. Excluding fraud, these kinds of blowups are generally caused by leverage (too much debt or financial derivatives with embedded leverage a.k.a convexity) and asset/liability mismatches.

It should be fairly straightforward for a competent analyst to identify and control these risks. More importantly, as analysts we should be getting these things right more often than not as they are triggers for catastrophically bad outcomes. What’s more, none of them is captured by backward-looking statistical measures.

Alignment of Interests

Recently, someone argued to me it’s not good if your personal portfolio looks too different from what you recommend to clients as a financial advisor. Generally, I disagree. However, there are certainly limits. If you are selling your ability to “pick winners” to clients and your portfolio is all index funds, for example, that is a problem.

If I am acting as a fiduciary, I am to act in clients’ best interests. Most clients will look nothing at all like me in terms of their goals, financial circumstances, risk tolerance and level of financial sophistication.

The biggest difference between me and a client would probably be our relative tolerance for tracking error. That is, our tolerance for investment performance that is very different from the broad market indices and our neighbors, who are inclined to chase momentum and do stupid things like borrow money to buy Bitcoin at the top.

Everyone wants to be +20 when the market is +10, or breaking even when the market is -10. No one likes being -5 when the market is +5.

Oddly, the pain of being -5 when the market is +5 seems more acute for clients than being -10 when the market is -10. For the client, the right thing to do is minimize tracking error and the pain of relative underperformance to make it easier for him to stick to his asset allocation and financial plan more generally.

What is more important than the optics of my portfolio is the alignment of interests in the advisor-client relationship. My financial incentives should be structured such that I am at all times incentivized to make decisions in my clients’ best interest.

Two And Twenty

Some people claim the hedge fund two and twenty (that is, a two percent management fee and twenty percent of profits) fee structure aligns the managers with their clients. This, too, is nonsense. It is a totally asymmetric payoff for the manager. The manager suffers nothing if performance is poor. The compensation structure is a free option that encourages excessive risk taking. That’s why it’s extra important for hedge fund managers to be personally invested in their funds and “eat their own cooking.” It creates symmetry in the incentive structure.

A financial advisor is not a hedge fund manager.

A hedge fund manager should be entirely focused on investment performance (here I am including risk management under the umbrella of performance). For a financial advisor, investment performance is at least two or three lines down the list, well below things like cash flow management and asset allocation. If a client is not generating free cash flow even Buffett’s returns won’t save him. Likewise, a client who is inclined to whipsaw herself to death trying to time the market will not benefit from clever security selection.

Increasing clients’ saving rates and dissuading clients from market timing have nothing whatsoever to do with the composition of the advisor’s investment portfolio.

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:

INDEX FUNDS DON’T SET THE RELATIVE WEIGHTS OF THE SECURITIES INSIDE THE INDEX. 

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:

180726_FB
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:

180726_FT_FB_Quote
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:

justified_pe_fade
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:

 

justified_pe_fade_inputs

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.

Ready?

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.