A Winner’s Curse

I have been having some interesting conversations recently regarding the latest trials and travails of cryptocurrency investors. The issue many of them are facing is what to do now having made returns of 5x, 10x, or more.

Do you let it ride and shoot for 1000x?

Do you lock in your profits now?

Something else?

In traditional markets, such as equity and fixed income, fundamental analysis helps with these issues. If you own Proctor & Gamble (PG) stock, and one day PG falls 50% for no reason other than that traders are bouncing the stock price around, you either: a) do nothing, or b) buy more. Although the market price has plummeted, there is no change in the intrinsic value of what you own (a slice of PG cash flows). In this case your valuation anchors you on what is important (intrinsic value) instead of the noise (the change in market price).

The challenge with cryptocurrency is that there is no intrinsic value for you to anchor on–at least not in the conventional sense. Holding forever and collecting your cash flows is not an option. There are no cash flows to collect. All you’ve got are supply and demand, and supply and demand are notoriously fickle over short time periods.

I have a pet theory that despite the meteoric rise in the price of Bitcoin, the average investor return is much, much lower. This would be consistent with investor behavior in traditional financial markets:


Of the municipal bond category, Morningstar’s Russ Kinnell wrote:

It’s surprising that the rather stable muni-bond fund group could be so misused, but it has been going on for a while. The problem here is that there are very risk-averse investors and a sector with scary headlines. The good news rarely makes headlines. Rather, investors hear about Puerto Rico’s crushing debt and Meredith Whitney’s ill-informed doomsday call. Those news events spurred muni investors to sell, which led to a drop in muni-bond prices and a spike in yields. Thus, they created a buying opportunity just as investors were fleeing. This speaks to the downside of trying to time the market and the benefit of staying focused on the long term.

Some Thoughts On Bitcoin Futures

I am increasingly involved in discussions about how futures trading will impact the spot price of Bitcoin. While I am far from a Bitcoin bull, I have attacked the notion that futures trading will somehow trigger a major correction in spot Bitcoin prices. This post will explain why.

First things first.

This is an intellectual exercise. It is not an investment recommendation. Do not under any circumstances make any decisions with real money (crypto or fiat) based on what you read here. See also my disclaimer at right. If you are serious about putting money into cryptocurrency, do you yourself a big favor and consult with a professional advisor who can provide guidance based on your unique circumstances.

Also, if you are not familiar with futures terminology, you are going to have to bone up on the following:

  • Futures
  • Term Structure of Futures
  • Contango
  • Backwardation
  • Futures Arbitrage

Khan Academy has a series of videos that looks decent. I simply don’t have the time to post a comprehensive introduction to futures on this blog. And frankly, if you are not willing to invest some time learning about markets and investing, you probably shouldn’t be spending time reading about digital lottery tickets in the first place.

Now, if you can explain to me why there is no arbitrage opportunity available on a 1-year Bitcoin forward priced at $12,600 with spot Bitcoin at $12,000, assuming a riskfree interest rate of 5%, you will follow my argument.

Why Bitcoin Futures Trading Will Not Trigger A Selloff

Whether the addition of futures trading will be bullish or bearish for Bitcoin depends entirely on the marginal trader of Bitcoin futures. The bear case assumes the market for Bitcoin futures will be dominated by hedgers and short speculators, and that this in turn will exert downward pressure on spot Bitcoin prices.

I disagree for two reasons:

First, market sentiment is euphoric. While there are certainly Bitcoin bears out there, it is difficult to imagine that they will dominate in futures trading. More likely futures will be viewed as a cheap way to get (leveraged) exposure to Bitcoin without the custody issues associated with owning Bitcoin outright in the spot market. I simply do not believe a bunch of professional traders are going to come out of the woodwork to short an asset with no intrinsic value, that people feel justified owning at $10 or $400,000. As a directional short Bitcoin is potentially lethal. Doubly so due to the leverage embedded in futures trading.

Thus, the term structure of Bitcoin futures is likely to be contango. Other than volatility and uncertainty there isn’t much reason for Bitcoin futures to trade in backwardation. If the spot market were wavering there might be an argument otherwise. But as noted above the spot market is euphoric. Therefore, futures traders looking for arbitrage opportunities will most likely be shorting longer dated Bitcoin futures and buying spot Bitcoin as a hedge (the goal being to earn roll yield with no directional exposure to Bitcoin prices). This argues for upward pressure on Bitcoin prices in the short term.

In order for futures trading to pressure spot Bitcoin downward, the term structure of Bitcoin futures will have to backwardate. This will encourage arbitrageurs to sell Bitcoin in the spot market and go long Bitcoin futures, putting downward pressure on spot Bitcoin prices.

What would cause the Bitcoin futures curve to backwardate? The Bitcoin narrative would have to break. Apologies in advance to enthusiasts but Bitcoin doesn’t trade on fundamentals right now. It trades on momentum (a.k.a sentiment). Skilled short sellers are not going to put big positions on unless the narrative breaks and sentiment turns. Otherwise they are going to get squeezed. Hard.

As equity short seller Marc Cohodes puts it:

I never, ever, ever get involved in what I would call open-ended situations. . . . I have avoided pie-in-the-sky names. To use an analogy, I’m not interested in climbing into a tree and wrestling the jaguar out of the tree. I’m interested in someone shooting the jaguar out of the tree, and then I will go cut the thing apart once it hits the ground. Instead of open-ended situations, I like to short complete pieces of garbage with fraudulent management and horrifically bad balance sheets. I look for change, I look for ‘if this goes away tomorrow will anyone miss them’?

No One Actually Understands Correlation, But (Hopefully) Now You Will

It is a common refrain these days among investment managers that “fundamentals don’t matter.” The market does what it does because of ________. (possible answers include: easy monetary policy; tech bubble v2.0; passive investing bubble) This makes all stocks go up together. With stocks so highly correlated it is impossible for a stock picker to succeed because “bad stocks” get rewarded just as much as “good stocks.” That is why passive investing is so popular. It is all one big, self-reinforcing bubble. When the pointy reckoning finally arrives all of us fancy active manager types will laugh our way to the bank.

I admit I am guilty of saying some of this stuff myself. Which I suppose makes me extra guilty because I understand correlation and how to interpret the statistic and am still using the term imprecisely.

Here is a good analysis by Aaron Brask on the Alpha Architect blog refuting this argument. He argues from first principles and even conducts a simulation to show that mathematically, correlation does not impact the expected returns of individual stocks. I will steal his chart because it is a convenient summary:


Mathematically, Brask’s argument is irrefutable. That’s the nice thing about mathematics. When you’re right, you’re right.

I will go further and argue that all this confusion about correlation stems from the fact that many finance professionals don’t actually understand it. They use a heuristic: “correlation = perform the same.” That is how they are used to explaining correlation to clients (and each other). The heuristic is fine for generic spiels about portfolio diversification but it can be dangerous when applied to actual portfolio management decisions.

I have encountered this on several occasions. For example, a colleague once asked if there was a mistake in a chart that showed the S&P 500 correlated nearly perfectly with a 50/50 blend of T-Bills and the S&P 500. My colleague was using that heuristic of “correlation = perform the same.” The two portfolios are indeed perfectly correlated. However, the historical return of the blended portfolio is much lower because T-Bills tend to return much less than stocks over time. This is exactly what Brask illustrates in his simulation.

Look again at his chart. Instead of focusing your attention on the return, compare the shapes of the line graphs. Pretty close, right? That visual similarity is indicative of high correlation. That’s because correlation measures similarity in the variation of returns, not similarity in returns themselves.

To illustrate further, here are three more visuals, graphing relative outperformance/underperformance of different portfolios over time.

The first is the S&P 500 versus itself (perfect correlation = 1):


The next is the S&P 500 versus the Bloomberg Barclays Aggregate Bond Index (correlation = basically 0 but in fact is slightly negative):


The final comparison is S&P 500 versus a 50/50 blend of itself and T-Bills (correlation = very near 1) :


Notice how in the first and third charts, the points plot in a straight line, while in the middle chart they are an uncoordinated blob. In this visualization, the more the plotted points resemble a straight line, the higher the correlation. The third chart shows a strong linear relationship but with much higher returns for the S&P 500 over the blended portfolio.

An improved heuristic for correlation is to think about the extent to which two assets share common risk factors. An investment grade bond index is mostly exposed to reinvestment and interest rate risk (seasoned with a pinch of credit risk). A stock index has little direct interest rate risk and almost no reinvestment risk. It is more exposed to the business cycle and economic variables such as real wage growth. Intuitively, you would expect very little correlation between stock index returns and bond index returns.

T-Bills have very little risk of any kind. Some people think of them as risk free. That is not entirely accurate but for this exercise it is a safe assumption. When you combine T-Bills with the S&P 500 the only relevant risk exposures are those of the S&P 500. They will drive 100% of the variation in portfolio returns over time, despite the fact that 50% of the portfolio is risk free. You can therefore expect high correlation with the S&P 500.

So when someone in the investment business says, “high correlations are bad for stock pickers,” she isn’t actually talking about correlation. What she actually means is, “market environments where investors don’t care whether they own good businesses or bad businesses make it difficult for active managers to outperform their benchmarks on a relative basis.” Hopefully she understands the difference intellectually and is just speaking imprecisely, using the “correlation = perform the same” heuristic for convenience. But you never know. People will trot out some pretty silly stuff when billions of dollars of fee revenue are on the line.

(Incidentally, if you are the type of person who likes to give prospective financial advisors quizzes before hiring them, this is a good topic to add to your list)

The Wrong Question

Where I work, we are not in the business of stock picking. Nonetheless, clients sometimes ask us to weigh in on individual equities. Often these questions come in the form of “should I buy Oil Company A or Pharma Company B?”

This is the wrong question. Even if you are proceeding from the assumption that stock picking is a worthwhile endeavor, it is the wrong question.

For starters, underlying this question is the assumption that at least one of the two stocks is a good investment. However, it is quite possible (even likely) that neither is a good investment. The entire exercise proceeds from flawed premises.

Unsophisticated investors almost invariably generate investment ideas based on availability bias. They don’t actively seek out non-consensus opportunities. They gravitate toward what they already know, or information that is readily available in the media or in stock picking newsletters (shudder). This in turn leads to “research” driven by confirmation bias.

People who grew up with a grandparent buying blue chip stocks for them like blue chips. People who work in tech like tech. Ditto for aerospace. And so on. This is also why so many people own large amounts of employer stock in their 401(k)s despite the vast body of personal finance literature advising otherwise. No ex ante consideration is given to risk management or opportunity cost–what the investor could earn in a broadly diversified equity portfolio.

Another problem with the question “should I buy Oil Company A or Pharma Company B?” is it completely ignores the issue of time horizon. Do you plan on holding this stock forever? For three years? For one year? For a couple of quarters? A day? As Cliff Asness is fond of saying, you don’t want to be a momentum investor on a value investor’s time horizon.

I consider myself a value-oriented investor, but I would bet on momentum over value for short time periods. In response to a question about performance evaluation, I once told a colleague I would be comfortable owning a certain mutual fund for the next 20 years, but not for the next 5. My statement was met with uncomfortable silence. From his reaction you would think I had spoken a koan. (I guess maybe I did)

I could go on by delving into financial statement analysis, but that’s beside the point. By using “should I by Oil Company A or Pharma Company B?” as a jumping off point you are skipping steps. You are making a security selection decision divorced from any larger context or purpose.

In other words, you are gambling.

Now, the purpose of this blog is not to admonish people for gambling. I enjoy the occasional negative expectation game as much as the next person. However, it is hazardous to your wealth to conflate gambling and investing.

The First Mutual Fund

Dutch East India Company bond from 1623; Source: Wikipedia

Today the mutual fund industry is a multi-trillion dollar business. It is amazing to think these structures, and other innovations we think of as “modern,” such as asset-backed securities, have their origins in the 18th century.

The material in this post is summarized from an article contained within a 2016 collection of essays, Financial Market History: Reflections on the Past for Investors Today, from the CFA Institute Research Foundation. Specifically, this material is from Chapter 12, “Structured Finance and the Origins of Mutual Funds in 18th-Century Netherlands,” by K. Geert Rouwenhorst.

You really ought to read the whole piece as it contains a wealth of fascinating information not summarized here. If you are the kind of person who is fascinated by the idea of structured finance for colonial plantations, that is.

Anyway, the first mutual fund was launched in 1774 by a Dutch broker and merchant, Abraham van Ketwich. Its name, Eendragt Maakt Magt (“Unity Creates Strength”), goes to show that fluffy marketing copy is as old as the asset management business itself.

Rouwenhorst sets the scene:

The first mutual fund originated in a capital market that was in many ways well developed and transparent. More than 100 different securities were regularly traded on the Amsterdam exchange, and the prices of the most liquid securities were made available to the general public through broker sheets and, at the end of the century, a price courant. The bulk of trade took place in bonds issued by the Dutch central and provincial governments and bonds issued by foreign governments that tapped the Dutch market. The governments of Austria, France, England, Russia, Sweden, and Spain all came to Amsterdam to take advantage of the relatively low interest rates. Equity shares were scarce among the listed securities, and the most liquid issues were the Dutch East India Company, the Dutch West India Company, the British East India Company, the Bank of England, and the South Sea Company. The other major category of securities consisted of plantation loans, or negotiaties,as they were known in the Netherlands. Issued by merchant financiers, these bonds were collateralized by mortgages to planters in the Dutch West Indies colonies Berbice, Essequebo, and Suriname.

The investment strategy and terms went something like this:

Investment Strategy

The fund’s objective is to generate income through investment in a diversified global bond portfolio.

To achieve its objective, the fund will invest approximately 30% of its assets in plantation loans in the British colonies, Essequebo and the Danish American Islands. The remaining 70% of its assets shall be invested in a broadly diversified portfolio of issuers including European banks, tolls and canals.

The fund shall also conduct a lottery, whereby a certain portion of dividends will be used to repurchase investors’ shares at a premium to par value, and to increase dividends to some of the remaining shares outstanding. (You know, just for fun)

Share Classes

The 2,000 shares of the fund shall be divided into 20 classes, each to be invested in a portfolio of 50 bonds. Each class shall contain 20 to 25 different securities to ensure a diversified portfolio.

Custody & Administration

The investment advisor (Van Ketwich) shall provide a full accounting of investments, income and expenses to all interested parties no less than annually.

The securities owned by the trust shall be held in custody at the office of the investment advisor. Specifically, securities shall be stored in a heavy iron chest that can only be unlocked through the simultaneous use of separate keys controlled by the investment advisor and a notary public, respectively.


The investment advisor shall receive an up-front commission of 50 basis points upon the initial sale of fund shares, and thereafter an annual management fee of 100 guilders per class of securities.

Rouwenhorst argues the driving force behind the creation of the fund was investor demand for portfolio diversification. To purchase a diversified portfolio of bonds would have been prohibitively expensive for small investors of the day. These investors may also have been gun shy following a financial crisis in 1772-1773, which nearly triggered defaults by several brokers.

Nonetheless, the fund endured a tumultuous trading history. By 1811 it was trading at a 75% discount to par (!) and was eventually liquidated in 1824, after making a final distribution of 561 guilders. Interestingly, Rouwenhorst notes that the fund actively repurchased shares when they traded at a discount–what looks to be an early form of closed-end fund arbitrage.

I do not have anything especially profound to conclude with here, other than to observe that financial markets have been complex and global in nature for quite some time. The first mutual fund is a perfect example.

Finding a Place in the Market Ecosystem

In my market ecosystem post I described different types of investors and the roles they might play throughout an idealized company’s life cycle. Writing that post caused me think more deeply about my own investing philosophy and the role I play in the market ecosystem (this is one of the reasons I write).

I used to think of myself primarily as a value investor: someone who is out there looking to pick up dollars for fifty cents. There is a still a part of me that is deeply attracted to these types of investments due to the margin of safety they afford.

However, another part of me is attracted to compounding machines. In order for an investment to compound over time it needs to generate high returns on capital and also offer ample opportunity to reinvest that capital for similarly high returns. This is identical to the reinvestment assumption underpinning the IRR and YTM calculations.

Traditional value investments may not compound very well. Many are maybe single digit revenue growers but with strong free cash generation. What keeps them from compounding at high rates is that the cash cannot be reinvested in growth initiatives (maybe the market is mature). Even worse, a management flush with cash may start doing stupid things to “buy” growth (such as play venture capitalist).

However, compounding machines tend to be more expensive than traditional value investments. It can be tough to find them with a fat margin of safety, particularly these days when valuations across the quality spectrum are stretched. This is mitigated somewhat by the fact that it is easier psychologically to hold a compounding machine for a very long time. A compounding machine by definition merits a richer valuation.

Therefore, what are more and more interesting to me are businesses that have reached inflection points. Ideally these are businesses that have been dumped by growth investors and are at increasing risk of being dumped by value investors but where the business nonetheless has a reasonable probability of inflecting positively. Low debt levels are important here as leverage can be catastrophic for a business in transition.

Here are some reasons I like this approach:

  • These businesses tend not to screen well on backward-looking quantitative measures. This makes them more likely to be overlooked and less likely to be owned by sophisticated investors facing pressure to deliver strong relative performance versus benchmarks (active mutual fund managers, pension funds, endowments). Taking a position in a stock at an inflection point introduces significant career risk into the equation for these players.
  • These businesses usually face significant uncertainty, which causes their market valuation to overshoot and undershoot significantly relative to intrinsic value.
  • If you fish for these businesses in the smaller cap segment of the market (under $1 billion and preferably $250 million or less) that is an additional constraint on large institutional investors that contributes to a structurally inefficient market niche.
  • If you are able to fish in the niche described above, the trading volumes for these stocks can be thin which means the price gets bounced around whenever someone buys or sells. This may present attractive buying opportunities as you build a position (but it can hurt if you need to exit the position in a hurry–another example of the advantages conferred by a permanent capital base).

The biggest risk to this investment approach is buying into a value trap. Thus, that ought to be the central focus of a risk management discipline. I am pondering how best to codify this but I think it starts with the decision to average down.

To summarize some valuable insights from John Hempton (whose portfolio management discipline I admire), one should never average down any of the following:

  • High leverage (financial or operational)
  • Technological obsolescence
  • Potential fraud

Related concepts I have been examining are use of the Kelly Criterion in position sizing and implementing some kind of explicit Bayesian updating process. Details to  be determined and perhaps discussed in a future post.

Life and Death in the Equity Market

Deep value investors at work.
In my humble estimation most investors have a limited view of the market ecosystem. This is the fault of the financial advice industry (which emphasizes performance comparisons to sell products and services) and also the financial media (which emphasizes performance comparisons even more than the financial advice industry).

When you look at markets from that point of view, there are “winners” and “losers.” The “winners” are always doing so at someone else’s expense. Usually mom ‘n pop. Or mom ‘n pop’s ineptly managed pension plan.

Make no mistake. Markets are competitive. But they are also vibrant and nuanced. As with any ecosystem, most of the “organisms” in the market contribute to its health in some way.

David Merkel tackles the market ecosystem in two excellent pieces:



Broadly speaking, he writes about the differences between “balance sheet players” such as banks and insurance companies and “total return players” such as hedge funds and mutual funds. These entities have different investment objectives and constraints and so behave very differently in the markets.

I want to go through a similar exercise. Of course, what is written below involves simplification and generalization. I also focus specifically on equity markets for simplicity. The real world is more complex. But I hope this helps readers think about markets in a more nuanced way.

Traders vs. Investors

At a very high level you can separate the market ecosystem into traders and investors. Traders have short time horizons (sometimes as brief as a few seconds, in the case of high frequency, algorithmic trading). Investors have long time horizons (sometimes as long as decades, in the case of Warren Buffett). Perhaps more importantly, traders and investors make different contributions to the health of the market ecosystem.

Traders’ Contributions To The Market Ecosystem

Traders buy and sell based on anticipated changes in the supply and demand for securities. They contribute to the health of the investment ecosystem by making markets and keeping bid/offer spreads narrow, which reduces the cost of trading for other market participants.

Arbitrageurs are a subset of traders that enforce price relationships among various financial instruments. For example, arbitrageurs ensure that ETF share prices track closely to their net asset values. You can read more about this process at ETF.com.

Many traders are completely unconcerned with the direction of markets. Rather, they attempt to capture small pricing inefficiencies at relatively high frequencies. 

Some traders simply execute transactions for longer term investors and attempt to do so as efficiently as possible. For a large investor that is far from a trivial task. It is one thing to buy $10,000 worth of KO shares and quite another to buy $10,000,000 worth of shares. The latter will move the market.

Investors’ Contributions To The Market Ecosystem

Investors buy and sell securities based on market prices relative to their estimates of “intrinsic value.” Investors contribute to the health of the market ecosystem by ensuring security prices properly reflect underlying economic value. Broadly speaking, there are two subspecies of investors in equity markets: value investors and growth investors.

Some people mistakenly believe value investors seek to buy assets at a discount to intrinsic value while growth investors buy at a premium. This is not true.

Value investors typically demand a much greater “margin of safety” (extra discount from intrinsic value) to buy a security. They tend to gravitate toward businesses that generate profit and excess cash flow, but have modest growth potential. An example of a value stock would be Exxon Mobil or another large integrated oil company. Growth rates are less important to value investors than cash flow and profitability. Value investors tend to focus on what could go wrong in the future versus the potential reward if things go well.

Growth investors gravitate toward businesses where future profits and cash flows are potentially much greater than they are today. These are stocks such as Facebook, Amazon, Netflix and Tesla. Some growth stocks are profitable today (Facebook). Others are kind of profitable (Amazon). Others generate large losses (Netflix, Tesla). The level of profitability today is of less concern to a growth investor than the potential profitability in the future. Growth rates and addressable market size, on the other hand, are of paramount importance to growth investors. Growth investors would prefer to own businesses that will change the world and accept the risk and uncertainty that goes along with that stance.

Popular misconceptions regarding value and growth investors stem from the fact that growth investors tend to own stocks that trade at relatively higher valuations, as measured by ratios such as price to earnings. Regardless, growth investors are always buying at a discount to their estimate of a stock’s intrinsic value.

Life And Death In The Equity Market

When a stock is born (or, rather, goes public), it may start as a high-flying growth company. The business may not be profitable, but as long as it is growing revenue and can capture an increasing share of a large addressable market then growth investors will own the stock. These investors ensure the stock’s price properly reflects the growth potential of the business. The main risk for a growth investor is that a company’s growth rate slows much faster than anticipated.

As a business matures, its growth rate declines and its market share stabilizes. Ownership will transition to value investors who will want to see profitability, cash flow generation and the return of cash to shareholders through dividends and share buybacks. The main risk for a value investor is that growth rates and markets never stabilize, but instead continue to spiral downward. This is called a “value trap” and it is a value investor’s worst nightmare. Another, less prominent risk is that the management will do stupid things like divert free cash flow or take on debt to do silly acquisitions to “buy” growth. A major reason value investors want to see free cash returned to shareholders is to prevent management from doing stupid things with it.

Most businesses will eventually enter terminal decline. There are many reasons for this but the outward signs include falling profitability, sharply declining market share and increasing amounts of debt. Eventually, if a company does not make significant changes, it will become insolvent. When a company reaches this final stage of its life cycle the “deep value” or “distressed” investor steps in to own the stock. The distressed investor evaluates the various securities in the capital structure to identify their value in a restructuring or liquidation. Thus the distressed investor seeks to buy at a discount to liquidation value. The main risk for a distressed investor is an adverse event or legal decision involving the business that unexpectedly changes the liquidation value of the securities in the capital structure.

When a company finally liquidates, its capital may ultimately end up recycled into young companies in the public and private markets.

And so the cycle can begin again.