Zombieland

Tallahassee: Bill Murray, you’re a zombie?
[Wichita hits Bill in his back with a golf club]
Bill Murray: [cries in pain] Ow, I’m on fire! Ouch!
Tallahassee: You’re not a zombie, you’re talking and… You’re okay?
Bill Murray: The hell I am.
Wichita: I’m sorry. I didn’t know it was… It was “you” you.
Tallahassee: Are you…? What’s with the get-up?
Bill Murray: Oh, I do it to blend in. You know. Zombies don’t mess with other zombies. Buddy of mine, makeup guy, he showed me how to do this. Corn starch. You know, some berries, a little licorice for the ladies. Suits my lifestyle, you know. I like to get out and do stuff. Just played nine holes on the Riviera. Just walked on. Nobody there.
Zombieland (2009)

I have been pretty depressed lately.

This is not just election fatigue (which is bad enough). It’s the feeling of watching a slow-motion train wreck. This is technically a Trump thing. Or, if you prefer, a corrupt Democrat/Deep State thing. It matters far less whether Joe Biden or Donald Trump ends up being president than it matters whether the perceived legitimacy of the electoral process is preserved. Trump’s intransigence and the Russiagate nothingburger are two sides of the same coin here. Does that mean they’re equally bad? I don’t know. For the purposes of this post, I don’t particularly care, either (if you would like to spend endless hours litigating this topic I recommend Twitter and the PredictIt comments section).

What both interests and disheartens me is that politically, these are two variants of the same strategy: subverting electoral outcomes as the ultimate arbiter of political power in the United States.

Regardless of the actual outcome, the common knowledge that elections are the ultimate, and more importantly, most legitimate arbiter of political power relations in the United States is dying a painful death. It is difficult to understate how massive a blow this is to the metastability of American society.

Longtime readers may recall some of my previous writing on the concept of metastability:

A superficial reading of metastability might make it seem like a breakdown in law and order. That’s not quite what I’m talking about here. Law and order might break down within an otherwise metastable social system. Whenever there’s a riot in an American city, for example, law and order break down. But a riot in and of itself does not alter the core values and mythology shared by American citizens.
A social system remains metastable as long as there is a reasonably broad consensus regarding its core values and mythology. Without this consensus, metastability weakens. Put another way: first-order threats to social stability, such as isolated riots and street crime, are risks that lie in the body of the distribution of outcomes, both for individuals and society. Metainstability is a higher-order threat. The risks associated with metainstability lie in the tails of the distribution.
Me

At the moment, the core modern American myth that is dying a slow and painful death is that the electoral system can more or less be trusted to produce a legitimate outcome and that outcomes should be respected as such. Of course this is a myth. Politics-as-it-is is basically the “lite” version of organized crime [insert your favorite Hillary Clinton joke here]. That’s the nature of the accumulation and exercise of political power.

Today, the nascent common knowledge forming around US elections is that The Other Side is so debased and so corrupt that any procedural end-around is justified to attain the desired outcome. And not just the desired outcome, mind you: also the just and morally correct outcome. It’s a rationalization of prisoner’s dilemma logic. We better defect. Defection isn’t really reflective of our moral character, of course, but The Other Side is going to defect anyway. So we gotta. Legislatively, this has been going for years. Its extension to the legitimacy of our elections is a natural, and ultimately more dangerous, evolution.

Joe Biden winning the presidential election does not change this.

Donald Trump overturning the result of the presidential election does not change this.

As my friends at Epsilon Theory have written endlessly, it is a very stable equilibrium.

Welcome to the future.

On the positive side, I am pretty skeptical of a worst-case outcome like Civil War 2.0. As depressing as the current climate may be, I think we’d have to fall an awful long way yet to get there. Rather, where I suspect we’re headed is the vague nothing-land of semi-permanent acrimony and sclerosis. Zombieland. In zombieland, no one ends up in a re-education camp (sorry in advance to resistance LARPers of all political flavors). When it comes to getting a tee time, or yolo’ing on Robinhood, things in zombieland are, on the face of it… kinda okay. For a lot of us, maybe even good. Even politics is just a matter of throwing on the corn starch and shambling around with the fellow zombies of your political tribe. Zombies don’t mess with other zombies, after all.

Trying to make 1:1 historical analogies is dangerous. But I do believe it is helpful to consider some historical analogues to get to grips with what this environment may look like:

Interwar France (my personal favorite)
Interwar Germany (overdone in the popular consciousness, IMHO, but definitely a worst-case case study)
Pre- and post-Civil War US (the Reconstruction era in particular)

Due to my personal background, I have come to think of our current trajectory as the Egyptification of the United States (I spent a year in Cairo immediately preceding the fall off the Mubarak regime).

You would think that chaos and revolution would feel pretty ominous and post-apocalyptic. It doesn’t. Mostly it feels weird. Your sense of time becomes distorted. Everything seems to slow down, because it’s a high information environment and it’s difficult to filter signal from noise. But you can’t revolution all day. You gotta eat. And you gotta try to figure out who’s still got booze. And if you are a young single guy you are still thinking about trying to get laid. It’s much more Zombieland than Dawn of the Dead.

Anyway, the defining characteristic of economic and political life under late-stage Mubarak was stunted sclerosis. To call the government inept was to miss the point. It wasn’t even trying.

Now, in Egypt circa 2009, the government wasn’t even trying because it was preoccupied with the maintenance of the regime and skimming off the economy.

In the US circa 2020, our so-called leaders aren’t even trying because they’re preoccupied with zero-sum power games, and skimming off the economy (one need look no further than the farce that has played out around a second Covid stimulus package).

History doesn’t repeat, but it rhymes.

I am still thinking through the investment implications of all this. My base case is now what I have called “the zombification of everything.”

MOAR dysfunction. MOAR debt. MOAR government intervention in capital markets (to hedge the political class from the financial consequences of its own ineffectiveness, ‘natch). Low rates, low growth, (alleged) low inflation, as far as the eye can see. The market narrative cartoon of this regime will be disinflation. In reality, I think it’s more of a stagflationary regime. But the cartoon is what matters for your returns. So somewhat paradoxically, this is GOOD for risk assets. Particularly long duration assets.

What would make me bearish?

Less. Less debt, less government intervention in capital markets and less dysfunction would, paradoxically, be BAD for risk assets. (Okay, maybe not value stocks) There is, therefore, very little economic incentive for the incumbent political class to go this route. From an economic policy perspective, we have a pretty stable equilibrium.

Up is down. Black is white. Such is life in zombieland.

By Any Other Name

A: If we call things like long-biased equity long/short funds and private equity equities instead of alternatives, it will look to these people like they are 90% invested in equities.

B: But they ARE invested 90% in equities.

One of the more dangerous things you can do in the markets is engage in self-deception. This is particularly true from a risk management perspective. A hill that I will die on is that much of what we call “alternative” investments are just equity investments by another name.

Nowhere is this more obvious than private equity. In what “bucket” of an asset allocation would you put a thinly traded, leveraged microcap stock that is no-bid for an extended period? There is no debate. It is an equity security. The economic risk exposures of the security are equity risks. Now, this is not a particularly liquid equity. But it is an equity security nonetheless.

Likewise, on the other end of the spectrum, a “defined outcome” S&P tracker with an options overlay is an equity strategy, exposed to equity risk. The addition of a mark-to-market volatility mitigating hedge does not transmute this into some kind of alternative strategy. It is just watered-down equity risk (with watered-down equity returns to match).

I have written about this kind of smoke and mirrors before.

Just because you have exposure to a bunch of different colored slices in a pie chart does not mean you have exposure to a bunch of differentiated sources of risk and return.

As I wrote in that post, I am NOT telling you that you shouldn’t be invested 90% in equities. That is a whole other debate. I am telling you to own your shots. Commit.

For most allocators and private investors, I suspect fiddling with phony-alternative, pseudo-equity strategies is akin to the golfer who is afraid to commit to an approach shot because of some windage. He is afraid of the wind so he clubs down. But because that club selection is driven by anxiety, he doesn’t hit as firm a shot as he normally would have. So he misses short and lands in a greenside bunker.

Don’t miss short! Get it past the hole!

There is an insidious thing that happens when you do not call things by their proper names. Things-as-they-are are gradually replaced with abstractions. This is what is happening with obvious absurdities such as private equity being pitched as “higher returns with less volatility.” From an economic risk perspective, the whole idea is nonsense. But as an abstraction bolstered by “statistics,” it is true.

Of course, I can reduce the volatility of my public equity portfolio, too. I will just mark it once a year, to my proprietary fair value estimates. My down capture will look great versus the S&P. My numbers will be audited and everything. Beautiful!

It is in periods of extreme dislocation that things behave as they are. This is when it becomes obvious that your long-biased equity hedge funds actually capture a decent amount of downside; and your high yield bonds behave a lot more like equities than you thought they would; and that bright hedgie who did a really good job of getting his net down at the start of the selloff keeps it flat into a massive rally… sorry… I digress…

The most egregious portfolio failures, in terms of both missed return targets and poor risk management, result from a failure (or even outright refusal) to see things as they are.

You can call your pie chart slices whatever you want. They can display all the colors of the rainbow. It does not change the underlying nature of the things they represent.

Quick Thoughts On Geopolitical Risk

Most nation states are fairly rational actors. Iran. North Korea. Even Libya under Qaddafi and Iraq under Saddam. These are not the kinds of regimes I would like to live under. But they are not irrational in their foreign policy agendas, either. Don’t mistake what a head of state says for what that state will actually do. Even the most vile, tyrannical regimes are first and foremost concerned with self-preservation. It isn’t in their interest to start wars they can’t win.

What they are solving for is the optimal mix of shenanigans to maximize geopolitical power and domestic prestige while minimizing existential risk. If you are the kind of person who thinks only OTHER countries operate this way, you have a lot to learn about geopolitics.

But.

Sometimes rationality does not prevail in international relations. Or, for idiosyncratic reasons (see WWI), what appears to be a series of rational actions when taken in isolation ultimately leads to an irrational outcome.

Hence, in my view we tend to overestimate the frequency of severe geopolitical shocks and underestimate the severity of the shocks that will inevitably occur. In other words, we are really, really bad at handicapping expected values related to geopolitical risk.

The obvious lesson?

QUIT TRYING TO PREDICT GEOPOLITICAL SHOCKS AND IGNORE ANYONE WHO CLAIMS TO BE ABLE TO PREDICT THEM.

Now, I enjoy reading foreign policy think-pieces as much as the next guy. Maybe even more than the next guy. (Fun Fact: Many moons ago I took the FSOT. At the time, you took the exam and wrote the essays separately. I passed the exam but promptly failed the essay section. In retrospect, I was almost certainly disqualified for ideological unreliability) Anyway, the way to read a foreign policy think-piece is as a scenario–a scenario that might play out in a grand strategy game like Hearts of Iron. This is essentially a speculative activity (the parallels with investment research should be obvious). The fact of the matter is that this stuff is useful for getting you to think about a range of possible futures and strategic options. It is NOT useful for actually predicting the future.

In practical terms, the way you manage geopolitical risk is with hedges and rules-based guardrails. Personally, I’d rather ignore geopolitical risk all together than make predictions based on subjective probabilities.

This is relatively simple, process-over-outcome and OODA loop stuff. There are dozens, if not hundreds of ways to adapt a portfolio to geopolitical risk without predicting anything. And 99.99% of what’s written about geopolitics is trash, anyway. Per the above, that’s kind of the point.

The challenge here isn’t identifying the right tools, or even understanding the tradeoffs they entail.

The challenge is shot commitment.

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.

Needful Things

Mr. Gaunt steepled his fingers under his chin. “Perhaps it isn’t even a book at all. Perhaps all the really special things I sell aren’t what they appear to be. Perhaps they are actually gray things with only one remarkable property—the ability to take shapes of those things which haunt the dreams of men and women.” He paused, then added thoughtfully: “Perhaps they are dreams themselves.”

–Stephen King, Needful Things

If your job is to sell people stuff, the path of least resistance goes something like this:

1) Sell cheeseburgers to fat people

2) Sell advice on giving up cheeseburgers to fat people

The point here isn’t to poke fun at fat people. The point is that “fat person” is an identity with a lot connotations attached to it. One might go so far as to call those connotations “baggage.”

Other identities with a lot of connotations attached to them include: “retiree,” “former executive,” “doctor,” and “little old lady who wants a good rate on her CDs.”

We’ve all got identities. We’ve all got baggage. We’ve all got cravings.

Salespeople know this.

I opened this with a quote from Stephen King’s novel. Needful Things. In the novel, Leland Gaunt sells trinkets. The trinkets take the form of something that matters to you. Whatever triggers your deepest desires and fears. And, of course, Leland Gaunt’s willing to give you a deal on that particular item. All he asks in return is a little favor…

You go into Leland Gaunt’s shop thinking you’ll shell out some cash for a trinket. A rare baseball card. A lampshade. A religious relic. But the true cost is your soul.

Investment products, too, are things that matter. They trigger powerful emotions. You come to associate them with your aspirations, hopes and dreams.

People who sell financial products know this. People who sell deals know this.

“Oh, so you’re a Little Old Lady Worried About The Market? We’ve got an equity indexed annuity for you.”

“Sophisticated allocator? I see private equity co-invests have caught your eye.”

“Tech entrepreneur? Have you ever looked at crossover biotech funds?”

The Leland Gaunts of the investment world traffic in symbols and memes:

Yield!

Diversification!

Innovation!

Security!

Sophistication!

Tax Breaks!

Deals!

I hate to break it to you purists, but most investments aren’t sold on the basis of future expected cash flows. Most deals are sold as little gray things that will satisfy whatever cravings you’ve got as a retiree or endowment CIO or little old lady looking for the best rate on a CD. Whatever matters to you, there’s a broker out there who will sell it to you.

And you’ll probably get a deal.

Caveat emptor.

(major h/t to Epsilon Theory for inspiring this post)

Ode To Liquidity

When it comes to risk management there is one consideration that towers over all the others. That is liquidity.

The word “liquidity” can mean different things in different contexts. Sometimes it literally means “cash.” Other times it refers to your ability to quickly convert the full value of another asset (like a stock or a mutual fund share) into cash. This post will reference liquidity in both contexts.

Liquidity (“cash”) is the lifeblood of our financial lives. It is the medium through which we move consumption forwards and backwards in time. It is the bridge that links spending, saving and investment.

You don’t fully appreciate the importance of liquidity until you need it and don’t have it.

Poor people understand this intuitively. For a poor person life is a never-ending liquidity crisis. It is the global financial crisis on repeat. There’s a reason the foundation for all financial planning is the net cash emergency fund. The net cash emergency fund is your liquidity buffer. It’s loss-absorbing capital. It’s what keeps you from getting caught in the vicious cycle of dependency on short-term, unsecured, high cost debt like credit cards and payday loans.

Funnily enough, there are plenty of rich people who live life on the edge of a liquidity crisis. Some of these people have a large amount of their net worth tied up in real estate or private business ventures. You can have a lot of paper wealth but still very little liquidity.

When the shit hits the fan, your paper net worth is irrelevant. If you don’t have enough cash on hand to meet your financial obligations, you are toast. This is the story of every banking crisis in the history of finance.

Sure, you can sell the illiquid things you own to raise cash. But that takes time. And the less time you have to sell the worse your negotiating position gets.

There is nothing a shrewd buyer delights in more than finding a forced seller who’s running out of time. This is the essence of distress investing. Distressed investors are often able to buy good assets for fractions of their value because the sellers are desperate for liquidity.

Does this mean you should never own illiquid things?

No!

It means you should never assume you will be able to sell an illiquid thing at a favorable price at a place and time of your choosing.

As an individual, how do you know if it’s okay to own an illiquid thing?

If you can write it down to zero the moment you buy it, and it will not impact your ability to make good on your day-to-day obligations, it is okay to own the illiquid thing from a liquidity standpoint. The thing may still turn out to be a terrible investment, but that’s a separate issue.

These days there are lots of things being marketed to regular folks that are illiquid things disguised as liquid things. These are things like interval funds–the mutual fund world’s answer to private equity. These are also things like non-traded REITs with redemption programs that allow you to withdraw, say, a couple percent of your investment every quarter.

Perhaps your financial advisor has pitched one of these things to you.

Read the fine print!

The underlying assets in these funds are illiquid, and the fine print always allows the investment manager to suspend your redemption rights. Third Avenue Focused Credit investors thought they had daily liquidity, like in any other mutual fund.

Ask them how that worked out.

The Alchemy of Risk, Revisited

In a meeting last week an asset manager predicted that whenever the next major market drawdown occurs, a massive central bank intervention will immediately follow. This will prop up asset prices. The drawdown will be brief and v-shaped.

The natural follow-up question: how long can this go on?

In theory, of course, it can go on forever. As long as market participants are willing to believe in the infallibility of ever-wise and benevolent central bankers, the Fed can effectively outlaw market crashes.

But that implies central bankers can somehow destroy financial risk. We know from market history risk can never be destroyed. It can only be transformed and laid off elsewhere.

So, what kind of risk transformation underlies this process?

What’s happening is financial risk is being transformed into political risk. Or, if you prefer, market volatility is being transformed into political volatility.

In an old Epsilon Theory note, Ben Hunt describes central banks as “creatures of capital:”

Not to get all Marxist here, but these vampires share the DNA of Capital, in opposition to the DNA of Labor, and this is why you will never see the Fed or any other central bank lift a finger against them. Because the Fed is also a creature of Capital — not a vampiric destroyer as these modern manifestations of Capital have become — but a creature of Capital nonetheless.

Meaning what, Ben? Meaning that all of the Fed’s policies — and particularly the monetary policies that are most impactful on our investment portfolios — are in the service of Capital. Sometimes, as we’ve experienced over the past eight years, that means incredibly accommodative monetary policy to support asset collateral prices. Sometimes, as we’ve seen in the past and I think we’re about to see again, that means punitive monetary policy to crush labor and wage inflation.

Pop quiz: What do President Donald Trump and Alexandria Ocasio Cortez have in common?

Answer: They’re creatures of Labor.

In the case of Trump that might seem like a controversial statement. But think about it. Do trade barriers serve Capital or Labor? Does restrictive immigration policy serve Capital or Labor? Cheap imports and immigrant labor sure are good for Capital. Not so much for Labor.

There’s certainly more nuance to it than that. There’s an argument to be made that Trump merely duped the voting public into seeing him as a creature of Labor. But for the purposes of this post that’s irrelevant. In politics, all that matters is what the crowd believes. (Enough of the crowd to sway an election, anyway)

Trump speaks the language of Labor in front of crowds of steel workers and the like who have spent decades on the pointy end of globalization. Likewise when Ocasio Cortez talks about “economic dignity” she’s speaking the language of Labor.

The way Labor traditionally puts the hurt on Capital is through collective action. Ideally that’s political participation and modest civil disobedience. But in the worst cases it’s violent revolution. (Talk about tail risk)

Speaking of tail risk–a similar dynamic is afoot in China.

China’s economy is more or less run as a closed system. This is extremely important for the CCP, which needs to be able to push imbalances around the system to keep it from collapsing. There’s an argument to be made that the Chinese economy is a perpetual game of whack-a-mole with the CCP always needing to pop a bubble here and let another one inflate there.

This is another dynamic that can in theory go on forever but for villagers-with-pitchforks risk. There’s a practical reason the Chinese government has constructed a massive surveillance state.

It’s the tail hedge.

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.

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.

“To the moon!”

From The McKinsey Global Private Markets Review 2018 (subtitle: “The rise and rise of private markets”):

McKinsey_PE_Rocket_Ship — Source: McKinsey

Your eyes do not deceive you. That is literally a rocket ship with stabilizer fins made of dollar bills, blasting off into the stratosphere. I like to imagine it’s headed off to join the crypto people and their lambos on the moon.

A few highlights from the introduction:

“Private asset managers raised a record sum of nearly $750 billion globally, extending the cycle that began eight years ago.”

“Within this tide of capital, one trend stands out: the surge of megafunds (of more than $5 billion), especially in the United States, and particularly in buyouts.”

“What was interesting in 2017, however, was how an already powerful trend accelerated, with raises for all buyout megafunds up over 90 percent year on year.”

“Investors’ motives for allocating to private markets remain the same, more or less: the potential for alpha, and for consistency at scale.”

This is what you see when an asset class gets frothy. And private equity is an asset class I have had my eye on for a while now. As I have written before, and as McKinsey says somewhat obliquely in their report, institutional investors have come to view private equity as a magical asset class.

We have seen this movie before. It happened with hedge funds in the early 2000s (spoiler alert: it ends with capital flooding into the space and diminished future returns). There are no magical assets. People ought to know better by now. I guess the allure is too powerful. Particularly for return-starved pension systems.

Anyway, when this thing turns there are going to be knock-on effects in a couple of other areas: namely high yield debt and leveraged loans. The gears of the private equity machine are greased with high yield debt. These days there is a strong bid for crappy paper. Especially crappy paper with floating rates.

The yield on the S&P/LSTA US Leveraged Loan 100 Index is something like 5%. Meanwhile, 2-year Treasuries yield 2.5%. And loan covenants suck, which means when defaults inevitably tick up recoveries are going to suck. Buyers are so fixated on interest rate risk they’re overlooking the credit component. You can keep your 250 bps of spread, thanks. Doesn’t seem like a great risk/reward proposition to me.

If I were a big institution, I would be swimming damn hard upstream against consensus on private equity.

If I were a financial advisor, I would steer clear of floating rate paper, rather than reach for a bit of yield so I can tell my clients they’re insulated from interest rate risk.

If I were a distressed debt investor I would make damn sure I had access to liquidity for when these deals start to explode (indeed, many distressed funds are out seeking commitments for exactly this purpose).

The institutional investors will screw it up, because they’re organizationally incapable of swimming upstream. Most of the financial advisors will screw it up, too, because they don’t really understand what they own in a bank loan fund and they tend to fixate on past performance data, which isn’t as relevant to the current environment. The distressed debt guys and gals will make a bunch of money for a few years picking through the shattered ruins of these deals. That, I admit, warms my heart. The distressed folks have had a rough go of it lately.

This whole dynamic is a great example of how investor psychology drives market cycles. To play off that tired old hockey analogy: investors don’t skate to where the puck is going, they skate toward the player who last handled the puck.

Here the puck is going to stressed/distressed debt.

It is most definitely not going to the moon.