The Ministry Of Love: A Play In One Act


(We open on a nondescript, windowless room. A FUNDAMENTAL INVESTOR sits strapped into a GROTESQUE TORTURE CHAIR. The torture chair is designed to inflict the physical, psychological and financial pain of enduring a short squeeze on its occupant. An ECONOMIST dressed in an ordinary suit addresses the investor)

ECONOMIST: I would like to begin by emphasizing we have invited you to this Continuing Education Session in the spirit of educational goodwill. Here at the Ministry, we work not for money, but out of love. Our love for you. Our love for your fellow investors. Our love for the financial markets and the global macroeconomy. Now, we shall begin today’s session by reviewing some simple concepts. What is a financial market?

INVESTOR: A financial market is where buyers and sellers– (mid-sentence, the Investor convulses in pain, letting out a guttural sound that is half-grunt and half-scream)

ECONOMIST: –Already we are starting off on the wrong foot. A financial market has nothing whatsoever to do with buyers and sellers. A financial market is a wealth creation mechanism for individuals and thus societies. Now, what do you suppose a market should do over time?

INVESTOR: It depends– (again the Investor convulses in pain)

ECONOMIST: Incorrect. The correct answer is RISE. A financial market RISES over time. Can you tell me why?

INVESTOR: Earnings– (another convulsion)

ECONOMIST: WRONG AGAIN! A market rises because a market MUST rise over time. It is a tautology that a market must rise. I am beginning to suspect your misconceptions about our financial system are more fundamental than I had initially believed. I shall endeavor to correct this. (The Economist pauses briefly, as if switching to a new script in his head) Tell me, why should someone invest?

(The Investor hesitates)

ECONOMIST: Go on. I am genuinely curious.

INVESTOR: To earn a return on capital.

ECONOMIST: Yes. To earn a return on capital. And why should an investor prefer bonds, to say, cash?

INVESTOR (hesitant): Higher returns.

ECONOMIST: Yes, quite right. And why should an investor prefer stocks to bonds?

INVESTOR: Higher returns.

ECONOMIST: And WHY do you suppose stocks should return more than bonds or cash over time?

INVESTOR: As compensation for the incremental risk associated with taking the most junior position in a capital structure, with only a residual claim on cash flows and assets.

ECONOMIST: Yes, very good. And how does an investor decide whether he is being compensated fairly for taking the most junior positions in capital structures, instead of owning bonds?

INVESTOR (after a long pause): Relative valuations.

ECONOMIST: And what determines relative valuations?

INVESTOR: Investor preferences– (this time the convulsion is extra long and painful)

ECONOMIST: Now we’ve arrived at the crux of our misunderstanding. You investors only BELIEVE you determine relative valuations across asset classes. You are so absorbed in your own brilliance, in your petty little security selection games and benchmark arbitrage games and sales and marketing games that you COMPLETELY AND UTTERLY FAIL to see the world AS IT IS. In reality, WE determine relative valuations. The Federal Reserve. The European Central Bank. The Bank of Japan. In nature, it would be as though we controlled the force of GRAVITY. Investors do not “determine” anything. They merely RESPOND to our influence as it manifests itself in the world. Can you tell me, whence we derive this incredible power?

INVESTOR (for the first time, calm and self-assured): You control the supply of money.

ECONOMIST: Not only the SUPPLY of money, but the PRICE of money. Said another way, we control the price of RISK. You investors can no more escape our influence on the price of risk than you can escape the force of gravity. Excellent. (The Economist is obviously delighted with this progress) Now that we’ve reached this understanding, we shall practice with a brief exercise. What is a reasonable return on Treasury bills?

INVESTOR: Depending on inflation–(a brief zap of pain)

ECONOMIST: Incorrect. Let us try again. What is a reasonable rate of return on Treasury bills?

INVESTOR: I need to know–(a longer convulsion ensues)

ECONOMIST (sighs): Again, what is a reasonable rate of return on Treasury bills?

INVESTOR (desperate; frustrated): I DON’T KNOW! Just tell me what you want to hear!

(This is the longest zap of the torture device yet, and when it ends the Investor is little more than a blubbering pile of mush)

ECONOMIST (to the audience): A reasonable rate of return on Treasury bills is whatever OUR models say it should be. A reasonable rate of return on Treasury bills is whatever WE want it to be. WE decide whether you should prefer bonds to bills, or stocks to bonds. WE decided whether you should be incentivized to hold cash or spend it with reckless abandon. WE decide whether the market should rise or fall. Only deciding whether the market should rise or fall is no decision at all. The market rises over time because it MUST rise over time. That the market rises over time is a tautology.

(Abruptly, the stage goes black)

(Scene change)

(Slowly, the lights come up. The Investor is seated at his desk, working. He is on a client call, holding his phone up to his ear. He is flanked by an enormous plasma TV, showing Neel Kashkari being interviewed on CNBC)

Investor (smiling broadly): Well, of course the market goes up over time, Mister and Missus Smith. The market pretty much HAS TO go up over time. It’s basically a tautology. (He pauses momentarily, listening) Of course! Happy to explain…

(Fade to black)

ET Note: Kobayashi Maru

I suspect I have some significant reader overlap with Epsilon Theory, but for those of you who aren’t also ET readers (you should be, btw), I was recently invited to contribute to the site. Perhaps needless to say, I jumped at the opportunity. I’m excited to join Ben, Rusty, Peter, Neville and David on a platform offering some of the most unique perspective out there on politics and investing. For now, I expect to contribute approximately one note every three weeks, and to cross-post the links to those notes on this site.

My first note went live Tuesday afternoon. It’s titled “Kobayashi Maru”, and it’s about how in a no-win scenario, the best strategy is to change the conditions of the game.

More specifically, it’s about discretionary active management and the way ESG investing is sold to investors and financial advisers.

And, obviously, it involves a Star Trek analogy.


Are Structured Products Trash?


I am not a fan of structured products.

For those of you who haven’t wasted hours of your life ruminating on the pros and cons of financial engineering, structured products are sold to investors as a custom package of risk exposures.

For example, you might buy a note that promises a guaranteed minimum value and potential upside participation in an equity index’s return. This is equivalent to being long a zero coupon bond and a call option on the underlying index.

Or, you might buy a reverse convertible that pays a fat yield in exchange for exposing you to downside equity risk. In this case you are long a bond and short a put (you are shorting volatility).

Here’s my beef with structured products:

  • They’re expensive.
  • Most banks are better than you and me at pricing options. The deck is stacked against us (this is not to be confused with the common misconception that the bank is on the other side of the trade when you buy a structured product–issuers hedge out their exposures).
  • Because structured products are such profitable products for banks, they have fat commissions attached to them and are often foisted on unsuspecting retail investors who have no idea what they own. For example, it’s easy to sell Yield! to unsophisticated clients (and some sophisticated ones, too).
  • Oh, by the way you’re an unsecured creditor of the bank, which is one of those things that doesn’t matter until suddenly it matters, and then it’s the only thing that matters.

Before I wrote this post, I solicited some feedback from folks on Twitter. I wanted to know: do you see any legitimate uses for these products? The responses I received boiled down to the following:

  • It can be difficult for individuals and institutions to replicate their desired exposures directly in the options market for structural reasons or due to governance constraints.
  • At times, banks screw up on pricing, or there’s an opportunity to put a trade on that’s so attractive it justifies getting your face ripped off on pricing (as one individual put it: “an obviously suboptimal implementation [may be] the best available implementation”).

Taking this all into consideration I’ll modify my stance on structured products somewhat. If you are good with options, and are able to decompose these structures to judge whether the embedded options are cheap or expensive, it may make sense to dabble in structured products. I certainly don’t begrudge anyone a clever way to make a buck. In fact, it warms the heart to know clever people have made a few bucks beating Wall Street at its own game.

Likewise, if the design of your portfolio absolutely, positively requires options exposure, and structured products are the only way to access that exposure, perhaps it makes sense.

But I suspect most of us are better off without them.

Mirror, Mirror


Captain James T. Kirk: What worries me is the easy way his counterpart fit into that other universe. I always thought Spock was a bit of a pirate at heart.

Mr. Spock: Indeed, gentlemen. May I point out that I had an opportunity to observe your counterparts here quite closely. They were brutal, savage, unprincipled, uncivilized, treacherous–in every way splendid examples of homo sapiens, the very flower of humanity. I found them quite refreshing.

Captain James T. Kirk [to McCoy]:  I’m not sure, but I think we’ve been insulted.

Star Trek, “Mirror, Mirror” (1967)

As any sci-fi nerd who reads this can likely attest, “Mirror, Mirror” is one of the best known Star Trek episodes. It’s an Alternate Universe story, with the all-too-common “transporter malfunction” serving as catalyst (aside: if transporter tech is invented in my lifetime I will never, ever use it). In the Mirror Universe, the Federation is instead the Terran Empire. Imagine all the worst impulses of the Roman emperors, applied on a galactic scale.

In Terran society, only the strong survive. Don’t like your boss? Kill him. You simply take what you want through violent force. Women. Resources. Power. It’s pure Social Darwinism.

A fairly horrifying way to organize social and economic activity, when you really stop and think about it. Imagine being tortured in the Agonizer Booth every month you underperform the S&P 500. Many of us would be on intimate terms with the Agonizer Booth by now.

But as Mr. Spock observes at the end of the episode, the Terrans are just an exaggerated expression of basic human nature. The kinder, gentler humans of the Federation share the same basic impulses. They have the same capacity for cruelty and violence.

They’re us. We’re them.

It’s the same in our relationships with our investment managers. Many of their failings, real and imagined, reflect our own weaknesses and failings, both as individuals and allocators.

Why are there so many overly diversified, low tracking error portfolios out there? The dominant methods allocators use to evaluate performance incentivize the construction of overly diversified, low tracking error portfolios.

Why do so many bottom-up managers dabble in macro tourism? Allocators have unrealistic expectations for how true bottom-up portfolios should perform during broad market selloffs.

Why does it feel like so little money is managed with an emphasis on “real world” cash flow generation by “real world” businesses? Because the dominant models for asset allocation are based on abstracted baskets of securities.

Why is does it feel like so much money is managed in a short-term, overfitted fashion? Clients want 200% upside capture and 0% downside capture, and they want it “consistently.”

Our flaws and biases as allocators manifest themselves in our managers’ portfolios. They’re amplified by the intense pressure that comes with managing other people’s money. We end up in a kind of nightmarish feedback loop. The more pressure a manager is under during a period of underperformance, the worse that feedback loop gets. The more exaggerated our flaws and biases become as they’re translated into security selection and portfolio construction.

I sometimes often laugh at the silly conversations I have with capital intro people and third party marketers. They’ll say things like: “Fund X was actually up in December 2018! You should really take a look.” As if that, on its own, is somehow a meaningful data point.

But I shouldn’t laugh.

I shouldn’t laugh because I made them this way. Me, and others in seats like mine. Ultimate responsibility for the pervasive absurdity in the investment management business lies with us. We not only tolerate it, but actively encourage it. We encourage it with our peer group rankings and tracking error parameters and quarterly performance evaluations, not to mention our fear and greed.

I’ve always loved Wes Gray’s take on this, using a poker metaphor:

On the other side of the table is an institutional poker player, hired by wealthy investors, to play poker as best as possible. This poker player is a pure genius, mathematically calculates all probabilities in her head, and knows her odds better than anyone. Now imagine that our super player, as a hired gun, has a few limits. “We need you to maintain good diversification across low numbers and high numbers. We also want to see a sector rotation between spades, aces, and clubs. Don’t take on too much risk with straights and flushes, stick to pairs like the market does…” No one would ever play poker like this. But in finance, this is how people play.

They’re us. We’re them.

Mirror, mirror.

Mortification of the Flesh


Jöns: What’s that rubbish there?

Painter: People think the plague is a punishment from God. Crowds wander the land lashing each other to please the Lord.

Jöns: Lashing each other?

Painter: Yes, it’s a horrible sight. You feel like hiding when they pass.

Jöns: Give me a gin. I’ve had nothing but water. I feel as thirsty as a desert camel.

Painter: Scared after all?

The Seventh Seal

The Seventh Seal is a film about the silence of God. It’s set in medieval Europe, during the Plague and the Crusades. The protagonist, the knight Antonius Block, spends the film looking for signs of God’s existence. He stalls Death with a now-iconic game of chess.

They just don’t make ’em like this anymore, folks. We’re too clever for movies that take religion so seriously. So literally. It’s all too earnest for The Age of Snark.

Anyway, as much as it’s about Antonious Block’s existential crisis, The Seventh Seal is about medieval European society’s response to the apocalyptic destruction wrought by the plague. And boy, it ain’t pretty. Inquisitors burn witches. Charlatan theologians prey on the weak and the naive. Flagellants wander from town to town, putting on bizarre religious displays.

Observing a procession of flagellants, Block’s squire mutters:

Is this what we offer to modern men’s minds? Do they really believe we will take all of this seriously?

As investors, we too wrestle with God’s silence. It’s not war or plague that shakes our faith but changes in the structure and behavior of financial markets. How do we respond?

Inquisitors burn witches.

Charlatan theologians prey on the weak and the naive.

Flagellants put on bizarre religious displays.

In many circles–particularly those of the fundamental discretionary persuasion–there has emerged a kind of millenarian cult mindset. We endure this suffering to purge our sins. To mortify the flesh. When The Great Reckoning arrives, the Algos and the Indexers and the Risk Parity Heretics shall be cast into the flames. And we, The True Investors, shall emerge from the hellfire unblemished, as did Buffett after the Dot Com Bubble.

Make no mistake. This is religion. Yes, the sermon comes with charts. There will be CAPE charts. There will be Value/Growth dispersion charts. There will be Active/Passive cycle charts. But these charts aren’t science. They’re religious icons.

As we begin meeting with clients, investment managers and management teams in 2019, I’d encourage us all to look at the arguments and data we’re being presented though this lens.

How much of what’s passed off as “analysis” is, in fact, religious fanaticism clothed in the language and trappings of science?

How much of what’s passed off as “analysis” is, in fact, religious art?

How often, when we laud “conviction,” are we just promoting the mortification of the flesh?

Mental Model: Market Regimes

Markets and economies go through cycles. We’re used to hearing about bull markets and bear markets. We’re used to hearing about economic booms and recessions. But we don’t talk quite as much about market regimes.

A regime is a particular iteration of a particular phase (or phases) of a market cycle. Understanding regimes is important because markets are adaptive systems. Investors respond dynamically to changes in the economic environment, since changes in the economic environment influence their preferences for different cash flow profiles. As I wrote here, these changing preferences are key drivers for asset prices.

What characteristics define a regime? Things like:

  • Economic growth
  • Inflation
  • Interest rates (cost of capital)
  • Credit expansion/contraction
  • Market volatility

Every market regime is a bit different, but regimes tend to influence investor behavior in relatively predictable ways (partly the intuition behind the old saw: “history doesn’t repeat, but it rhymes”). In a deflationary regime, investors sell stocks and buy long-dated Treasury bonds. In an an inflationary regime, investors sell long-dated bonds, while bidding up real assets. In a growth regime, investors will bid up stocks at the expense of long-dated bonds.

Of course, this is a massive oversimplification. Identifying and profiting from market regimes is no easy feat. That’s the goal of the top-down global macro investor, and it’s an extraordinarily complex and difficult task.

So what do us mere mortals take away from this?

We want to ensure our financial plans and investment portfolios remain robust to different market regimes. This doesn’t mean we have to become market timers or macro forecasters. It means we should be thoughtful about the bets we’re embedding in our portfolios.

Unintended Bets

Today, the consensus view is that we’re in a “lower for longer” regime. Low growth. Low inflation. Low interest rates. There are big secular drivers behind this. In developed countries, older populations need to save a lot of money to fund future liabilities. Lots of investment capital in need of a home pushes down the cost of capital. Technological advances have kept a lid on inflation in many areas of daily life.

If the regime is “lower for longer,” what you want to bet on is duration.

We can define duration in different ways. Usually we’re talking bond math. In this context, duration is the sensitivity of a bond’s price to changes in interest rates. The longer a bond’s future cash flows extend out into the future, the higher its duration. The higher the duration, the more sensitive the bond will be to changes in interest rates. The archetypical high duration asset is the zero coupon bond.

If the market regime is “lower for longer,” you have an incentive to bet on large cash flows further out into the future. Low rates and low growth mean the opportunity cost for making these bets is also low.

Duration isn’t just a bond thing. Every asset with cash flows also has duration. It’s just harder to quantify for equities and real estate because of the other variables influencing their cash flow profiles.

Your venture capital investments? They’re a duration bet.

Your small cap biotechs? They’re a duration bet.

Your cash burning large cap growth equities? They’re a duration bet.

All these things are attractive in a “lower for longer” world because they offer Growth! But they’re also sensitive to the cost of capital. In a world of cheap capital, it’s easy to convince investors to subsidize losses for the sake of Growth! If and when the regime changes, that may no longer be the case.

As much as we hate to admit it, our portfolios are products of our environment. It’s what people are talking about when they say “don’t fight the market” and “don’t fight the Fed.” They might as well be saying, “don’t fight the market regime.”

As I’ve written many times before, I’m not a fan of “all-in,” “all-out” calls. That doesn’t just go for market timing. It goes for all the unintended bets that seep into our portfolios over time.

Especially those driven by market regimes.

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”.

Messerschmitt Me 163B
Source: USAF

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:

Source: Morningstar
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.