ET Note: The Life Aquatic

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My latest for Epsilon Theory is about surviving and thriving in a highly financialized world. What’s financialization?

Financialization is all about using financial engineering techniques, either securitization or borrowing, to transfer risk. More specifically, financialization is about the systematic engineering of Heads I Win, Tails You Lose (HIWTYL) payoff structures.

In business, and especially in finance, we see this playing out everywhere.

Debt-financed share buybacks? HIWTYL.

Highly-leveraged, dropdown yieldcos? HIWTYL.

Options strategies that systematically sell tail risk for (shudder) “income”? HIWTYL.

Management fee plus carry fee structures? HIWTYL.

Literally every legal doc ever written for a fund? HIWTYL.

There are two ways to effectively handle a counterparty that has engineered a HIWTYL game: 1) refuse to play the game at all, 2) play the game only if you have some ability to retaliate if your counterpaty screws you. Legal action doesn’t count. The docs and disclosures are written to be HIWTYL, remember?

(aside: corporate borrowing can be viewed as management selling put options on a company’s assets. I’ll leave it to you to consider what that might imply about government borrowing)

You need to be in a position to hurt your counterparty for real.

You need to be in a position to hurt your counterparty economically.

A friend (who is not in finance) recently asked me about the relationship between the sell-side and the buy-side. His question was basically this: is the purpose of investment banking just to rip fee revenue out of people by whatever means necessary even if it involves deliberately misleading them to screw them over?

My answer is that the sell-side’s purpose is simply to facilitate transactions. For investment bankers, that means raising capital or advising on M&A deals or whatever. For sell-side research groups it means driving buy and sell transactions.

The sell-side does not exist to make you money.

You can do business with the sell-side. You can even respect the sell-side. But you should never trust the sell-side. The same goes for pretty much all business relationships. Especially transactional relationships.

We poke fun at the sell-side around here, but what we’re poking fun at is just the sell-side’s Buddha nature. The zen master Shunryu Suzuki described Buddha nature thusly:

“If something exists, it has its own true nature, its Buddha nature. In the Parinirvana Sutra Buddha says, “Everything has a Buddha nature,” but Dogen reads it in this way: “Everything is Buddha nature.” There is a difference. If you say, “Everything has Buddha nature,” it means Buddha nature is in each existence, so Buddha nature and each existence are different. But when you say, “Everything is Buddha nature,” it means everything is Buddha nature itself.”

If that’s a bit too inscrutable for your taste, consider the fable of the scorpion and the frog:

A scorpion asks a frog to carry it across a river. The frog hesitates, afraid of being stung by the scorpion, but the scorpion argues that if it did that, they would both drown. The frog considers this argument sensible and agrees to transport the scorpion. The scorpion climbs onto the frog’s back and the frog begins to swim, but midway across the river, the scorpion stings the frog, dooming them both. The dying frog asks the scorpion why it stung the frog, to which the scorpion replies “I couldn’t help it. It’s in my nature.”

Weapons Of Mass Destruction?

There is this meme out there that the increasing popularity of ETFs as investment vehicles is eventually going to blow up the world. This came up in a meeting I attended recently. Whenever I have these conversations what I take away from them is that a shocking number of financial market participants do not actually understand how ETFs work.

The meme goes like this: there are too many people investing through ETFs these days and when there is a nasty bear market they will all redeem from the ETFs at the same time and the ETFs will all explode. On the off chance you’re wondering how this meme got started this graphic should set you straight.

As you can see, if you’re an active equity mutual fund manager you’ve got several hundred billion reasons to portray the rise of the ETF as a harbinger of doom. And so here is the first and most important thing everyone needs to know about ETFs:

ETFs are not mutual funds!

From what I can tell, the ETF-As-Weapon-Of-Mass-Destruction meme is founded on the incorrect assumption an ETF is like an open-ended mutual fund or hedge fund that needs to liquidate holdings to meet redemption requests in cash.

That’s basically the opposite of how an ETF works.

An ETF is much closer in nature to a closed-end fund that can trade at a premium or discount to net asset value over time. The difference is that certain sophisticated market participants (“authorized participants”) can transact with an ETF issuer to create or retire shares. In theory, this mechanism should keep an ETF’s share price in line with its NAV (Arbitrage 101, friends).

Here is a helpful diagram, courtesy of ICI:

When individual investors like you and me want to sell ETF shares, we don’t participate in the creation/redemption process. We couldn’t participate in that process if we wanted to. Instead, we have to sell our shares in the secondary market like a stock. The price we can transact at is determined by supply and demand. This can be a blessing or a curse, depending on circumstances.

Some Grains of Truth

ETF investors do face risks as they transact in the secondary market. The biggest risk is that they become forced sellers when the market for a particular ETF is thinly traded. In that case, they’ll have to take a haircut to unload their shares. This is no different from what happens when someone tries to unload shares of an individual stock in an illiquid market. That’s Trading 101.

Thus, if you’re going to invest in ETFs you need to pay attention to liquidity. This goes for your personal liquidity (under what conditions might I become a forced seller of this security?) as well as market liquidity (are bid-offer spreads for this security going to stay reasonably tight across a range of market conditions?).

If, for example, you own the S&P 500 index in ETF form you probably don’t have much to worry about from a liquidity standpoint. This won’t protect you from behaving like an idiot as an individual, but it’s fairly unlikely you will ever have to part with your ETF shares at a 50% discount to NAV. In fact, the early S&P 500 ETFs have been battle-tested across a number of stressed market environments, including the global financial crisis. They have yet to explode.

If you own more esoteric things, however, (e.g. the EGX 30 index, high yield debt, bank loans, complicated VIX derivatives) you need to think carefully about liquidity. Shrewd traders will eat you alive if you try to unload esoteric stuff in a dislocated market. In general, it’s dangerous to assume a share of something can ever be more liquid than the stuff it owns or represents. Yes, bank loan and high yield ETF investors, I’m looking at you here.

But these risks aren’t unique to ETFs. They’re present with every exchange traded security. It’s just that mutual fund investors aren’t used to thinking about this stuff. They just buy or redeem each day at NAV.

In Conclusion

Never generalize about any security or type of security.

Securities are not inherently good or bad. Investing is not a morality play.

In fact, any time someone is presenting a security or investment philosophy as a black/white, good/bad, dualistic type of situation it’s a good sign he’s financially incentivized to sell you something.

There are smart ways to use ETFs and stupid ways to use ETFs. But that’s more a comment on investor behavior and specific implementations of ETF investment strategies than the structure itself.

The Relative Performance Game

I wrote in a previous post that much of what passes for “investing” is in fact just an exercise in “getting market exposure.” In writing that post, and in the course of many conversations, I have come to realize the investing public is generally ignorant of the game many asset managers are playing (not what they tell you they are doing but what is really going on under the hood). In this post, I want to elaborate on this.

Broadly speaking, there are two types of return objective for an investment portfolio:

Absolute return. For example: “I want to compound capital at a rate of 10% or greater, net of fees.”

Relative return. For example: “I want to outperform the S&P 500.” Or: “I want to outperform the S&P 500, with tracking error of 1-3%.”

We will look at each in turn.

How Absolute Return Investors Play The Game

The true absolute return investor is concerned only with outperforming his established return hurdle. The return hurdle is his benchmark. When he underwrites an investment, he had better damn well be underwriting it for an IRR well in excess of the hurdle rate (build in some margin of safety as some stuff will inevitably hit the fan). He will be conscious of sector exposures for risk management purposes but he is not checking himself against the sector weights of any particular index.

I emphasize “true absolute return investor” above because there are a lot of phonies out there. These people claim to be absolute return investors but still market their ~~products~~ funds to relative return oriented investors.

Guess what? The Golden Rule applies. If your investor base is relative return oriented, your fund will be relative return oriented. I don’t care what it says in your investor presentation.

How Relative Return Investors Play The Game

The relative return investor is concerned with outperforming a benchmark such as the S&P 500. Usually managers who cater to relative return investors also have to contend with being benchmarked against a peer group of their competitors. These evaluation criteria have a significant impact on how they play the game.

Say Amazon is 2.50% of the S&P 500 trading on 100x forward earnings and you’re running a long only (no shorting) fund benchmarked to the S&P 500. If you don’t like the stock because of the valuation, you can choose not to own it or you can choose to underweight it versus the benchmark (maybe you make it 2% of your portfolio).

In practice you will almost certainly own the stock. You may underweight it but you will own it at a not-insignificant weight and here’s why: it is a popular momentum stock that is going to drive a not-insignificant portion of the benchmark return in the near term. Many of your competitors will either overweight it (if they are ~~reckless~~ aggressive) or own it near the benchmark weight. Most of them will own it at or very near benchmark weight for the same reasons as you.

Sure, if you don’t own the stock and it sells off you may look like a hero. But if it rips upward you will look like a fool. And the last thing you want to be is the idiot PM defending himself to a bunch of retail channel financial advisors who “knew” Amazon was a winner all along.

The safe way to express your view is to own Amazon a little below the benchmark weight. You will do incrementally better if the name crashes and incrementally worse if the name rips upward but the effects will not be catastrophic. When you are ranked against peers you will be less likely to fall into the dreaded third or (god forbid) fourth quartile of performance.

This is the relative performance game.

Note that the underlying merits of the stock as a business or a long-term investment get little attention. The relative performance game is about maximizing incremental return per unit of career risk (“career risk” meaning “the magnitude of relative underperformance a client will tolerate before shitcanning you”).

If you are thinking, “gee, this is kind of a prisoner’s dilemma scenario” I couldn’t agree more. In the relative performance world, you are playing a game that is rigged against you. You are handcuffed to a benchmark that has no transaction costs or management expenses. And clients expect consistent outperformance. Good luck with that.

I am absolutely not arguing that anyone who manages a strategy geared to relative return investors is a charlatan. In fact I use these types of strategies to get broad market exposure in my own portfolio.

I do, however, argue that the appropriate expectation for such strategies is broad market returns +/-, that the +/- is likely to be statistically indistinguishable from random noise over the long run*, and that this has a lot to do with the popularity of market cap weighted index funds.

Corollary: Don’t Be An Idiot

If you are one of those high net worth individuals who likes to run “horse races” between investment managers based on their absolute performance, the corollary to this is that you are an idiot.

The guys at Ritholtz Wealth Management (see my Recommended Reading page) have written and spoken extensively about the problems with such an incentive system. It is nonetheless worth re-hashing the idiocy inherent in such a system to close out this discussion. It will further illustrate how economic incentives impact portfolio construction.

If you say to three guys, “I will give each of you 33% of my net worth and whoever has the best performance one year from now gets all the money to manage,” you will end up with a big winner, a big loser and one middle of the road performer. You will choose the the big winner who will go on to be a loser in a year or two. Except the losses will be extra painful because now he is managing all your money.

Here’s why. You have created an incentive system that encourages the prospective managers to bet as aggressively as possible. This is exacerbated by the fact that your selection process is biased toward aggressive managers to begin with. No self-respecting fiduciary would waste his time with you. People like you make for terrible clients and anyway a self-respecting fiduciary’s portfolio is not likely to win your ill-conceived contest. Your prospect pool will self-select for gamblers and charlatans.

In Closing

Incentive systems matter. Knowing what game you are playing matters. There is a name for people who play games without really understanding the nature of the games.

They’re called suckers.

*Yes, I know it is trivial to cherry pick someone ex post who has generated statistically significant levels of alpha. I can point to plenty of examples of this myself. Whether it is possible to do this reliably ex ante is what I care about and I have yet to see evidence such a thing is possible. Also defining an appropriate threshold for “statistical significance” is a dicey proposition at best. If you feel differently, please email me as I would love to compare notes.

Blood In The Water

I was reading a cryptocurrency report from Goldman Sachs this morning and stumbled upon the following chart:

ICO_vs_Venture_Capital_GS — Source: Goldman Sachs

Now, put those dates in the context of the Bitcoin price action (which I think is a fair approximation of investor appetite for cryptos more generally):

ICO_vs_Venture_BTC_Price_Chart — Source: Bloomberg / coindesk

This speaks to a corollary of The Golden Rule:* The market supplieth what investors doth demand. If people are willing to throw billions of dollars at crypto lottery tickets, you can bet they will find an ample supply of coins and tokens to invest in.

Another, perhaps more intuitive way of thinking about this is that “easy” money attracts “investors” like blood attracts sharks. The sharks come swimming, and if there is enough blood in the water a feeding frenzy will ensue.

This description from Wikipedia is rather evocative:

In ecology, a feeding frenzy occurs when predators are overwhelmed by the amount of prey available. For example, a large school of fish can cause nearby sharks, such as the lemon shark, to enter into a feeding frenzy. This can cause the sharks to go wild, biting anything that moves, including each other or anything else within biting range. Another functional explanation for feeding frenzy is competition amongst predators.

In boring old non-tokenized finance, this dynamic drives the credit cycle. Suppliers of capital get good deals when capital is scarce. They get crap deals when capital is plentiful. When capital is plentiful, and investors are overly trusting, capital ends up in the hands of miscreants and value destroyers (though admittedly, many value destroyers are well-intentioned). In fact, driven wild by greed and vying for deal flow, investors compete aggressively to offer capital on favorable terms to miscreants and value destroyers.

What kind of deal do you suppose you are getting when you exchange cold hard cash for a token with no protective covenants, that gives you no claim on equity or future cash flows, and which may not even exist yet?

1024px-White_shark_(Carcharodon_carcharias)_scavenging_on_whale_carcass_-_journal.pone.0060797.g004-A — Source: Wikipedia

* The Golden Rule: He who hath the gold, maketh the rules.

#ContrarianProblems

I am generally a contrarian by nature.

To illustrate:

I am skeptical of home ownership as wealth creating endeavor.
I do not like reading “popular” books or seeing “popular” movies for the sake of being able to have conversations about them.
In my view at least 50% of the episodes of Game of Thrones are time-wasting filler.
I am generally not that into big events that draw crowds (sports victory parades, Coachella, Burning Man or Fyre Festival–but there are exceptions).

Perhaps unsurprisingly this permeates my investment philosophy. Things I like right now include a Russian natural gas company, a Brazilian aerospace company and sub-Saharan African bank holding company (I have a North African/Middle Eastern bank on my watch list, too, if the valuation ever comes down to earth). This is not a recipe for outperformance. It is not investment advice. It is just who I am as an investor.

Being a contrarian investor is great. You have good company in people like Seth Klarman and Howard Marks. On the other hand, being a contrarian in the investment business is not nearly so pleasant.

Contrarian ideas are often hard to sell and investment committees are engineered to arrive at consensus decisions. Consensus decisions are generally good for business. Consensus decisions will not deliver top quartile performance but they will not deliver bottom quartile performance, either. You can have a very nice business and never deliver top quartile performance. But woe betide you if you end up in the bottom quartile. It may well be the end of your business.

I sometimes hear about firms that designate “devil’s advocates” on committees. The devil’s advocate’s job is to argue against every single investment thesis. She is not allowed to argue in favor, or to moderate her argument. She is a dedicated short and everyone knows it in advance. This is a neat solution to the problem of encouraging a contrarian viewpoint in a high pressure group setting (contrarians can often grate on their fellow committee members). But does it make any difference?

What percent of ideas get blown up because of the devil’s advocate? Or is the whole thing just an exercise in box-checking dreamed up to please consultants? I suspect in most cases it’s the latter.

Edward Hess summarizes the issue quite nicely in an article titled “Why Is Innovation So Hard?”:

Most organizational environments won’t help us overcome our fear of failure and build our innovative thinking skills. That’s because most organizations exist to produce predictable, reliable, standardized results. In those environments, mistakes and failures are bad. That is a problem. To innovate, you must simultaneously tolerate mistakes and insist on operational excellence. Many businesses struggle with implementing that dual mentality.

Here we can learn from exemplar companies like IDEO, Pixar, Intuit INTU -1.84%, W.L. Gore & Associates, and Bridgewater Associates. In those organizations, mistakes and failures are redefined as “learning opportunities.” IDEO takes it even further, characterizing failure as good because it helps people develop the humility that is necessary for empathy—a critical skill in user-centric innovation.

But in many workplaces, people do not “feel safe enough to dare.” They don’t necessarily feel that they can speak with candor up and down the organization. Can you tell your boss the truth? Innovation occurs best in an “idea meritocracy,” a culture where the best evidence-based ideas win. There can’t be two sets of rules—everyone’s ideas must be subject to the same rigorous scrutiny. As Ray Dalio, the founder of Bridgewater Associates, one of the largest hedge funds in the world, so bluntly said, “We all are dumb shits.” That’s why everyone at his company is engaged in a radically transparent “search for truth,” which involves candid feedback and a deliberate effort to “get above yourself,” to get past the emotional defenses that inhibit our thinking.

In other words, organizational incentives are skewed toward rewarding preservation of the status quo. If The Golden Rule is “He who hath the gold, maketh the rules,” surely immediate the corollary is “He who f***eth with The Golden Goose shall meet with a pointy reckoning.”

#ContrarianProblems.