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.

My Definition Of Wealth

I am not motivated by money.

That may sound strange coming from someone who works in investment research, and I certainly don’t mean to imply I don’t care about money at all. I have to make money to live a certain quality of life. Money will also allow me to achieve financial independence some day. So maybe I am motivated by money and I just define wealth differently than others.

For me, wealth is not an extravagant lifestyle, a huge mansion or fancy cars and clothes. Rather, wealth is financial security and independence. Wealth allows you to write and say what you want, when you want, and how you want. Wealth is “fuck you” money.

While I try not to curse much on this blog (requiring a herculean effort at times), it’s important to me that bit of profanity be written out in full. To sanitize the statement is to diminish its power.

The link is to a post by J.L. Collins:

If memory serves, it comes from James Clavell. In his novel “Tai Pan” (highly recommended BTW) a young woman is on the quest to secure 10 million dollars. She calls it her “F-you money,” although the F-word is spelled out in the book. So you can look it up in case you’re wondering just what word it is. And 10m is far more than it takes, at least for me. More monk than minister.

I may not have known what it was called, but I knew what it was and why it is important. There are many things money can buy, but the most valuable of all is freedom. Freedom to do what you want and work for whom you respect.

Those who live paycheck to paycheck are slaves. Those who carry debt are slaves with even stouter shackles. Don’t think for the moment their masters don’t know it.

Much of what we believe about wealth we accept without critical thought. It does not help that we are inundated with messaging glorifying conspicuous consumption. What was the Fyre Festival but a monument to conspicuous consumption and personal vanity? What does it say about conspicuous consumption that the whole event ended up being a massive fraud?

Simply taking the time to examine our beliefs about money, wealth and power has the potential to redefine our worldview and change our lives. At a bare minimum we will better understand ourselves. We might also avoid being stranded on Caribbean islands without access to food and shelter.

Investing Like John Wooden

These days it is more or less common knowledge that our brains are not evolved for investment success. In fact, our brains are evolved to keep us from investment success. I don’t have anything profound to say on the science behind this. If you are interested in the science, I would recommend reading Thinking, Fast and Slow, by Daniel Kahneman.

Rather, I want to focus on how we can deal with our evolutionary disadvantages.

There is much investing literature insisting the solution to our cognitive and emotional biases is simply to think as dispassionately and analytically as possible. That sounds nice on paper. However, I don’t think it is realistic. I don’t believe it is possible to completely cut emotion out of the investment process. I would argue that if you think you have successfully removed emotion from your investment process what you have really succeeded in doing is deceiving yourself.

It is both healthier and more productive to openly acknowledge that investing is a difficult, emotional process. Better to channel your emotions toward productive ends than waste time and energy denying they exist.

For me, this means measuring success by the quality of your investment process and the consistency of its implementation–not the daily, weekly, monthly or even annual tape print. If you have a quality process and implement it consistently, and you strive for continuous improvement, you will do okay in the long run.

Think of this as the John Wooden approach to investing:

When Wooden arrived at UCLA for the 1948–1949 season, he inherited a little-known program that played in a cramped gym. He left it as a national powerhouse with 10 national championships—one of the most (if not the most) successful rebuilding projects in college basketball history. John Wooden ended his UCLA coaching career with a 620–147 overall record and a winning percentage of .808. These figures do not include his two-year record at Indiana State prior to taking over the duties at UCLA.

What’s more, Wooden openly shared his secret sauce:

Here are a couple of the ways I strive to channel emotion into process and not into a self-defeating obsession with outcomes:

I keep an investing journal where I document research, investment theses, thesis breaks, trades and post-mortems of exited investments. I will also write own my feelings and views of difficult situations or frustrating outcomes.
My emphasis is always on following my process. Making money on random gambles or “lottery ticket” type investments doesn’t count as success. My process does not revolve around “making money.” The goal of my process is to validate or disprove investment theses.
Thus, selling out of a bad investment is not failure. Exiting bad investments quickly allows me to redeploy that capital into better quality investments. Some of the worst investing mistakes (think Valeant) have been made by people being unwilling to admit they are wrong.

For a process-oriented investor, much of what passes for “investing” seems silly–like poker players on a tilt or dogs chasing cars.

#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.

Why We Believe What We Believe

Most people do not reason from first principles when developing their political views. Rather, they develop a set of views based on their life experiences and retrofit facts and narratives to conform with that worldview (myself included). How else do you explain something like the backfire effect?

David McRaney of You Are Not So Smart writes:

Geoffrey Munro at the University of California and Peter Ditto at Kent State University concocted a series of fake scientific studies in 1997. One set of studies said homosexuality was probably a mental illness. The other set suggested homosexuality was normal and natural. They then separated subjects into two groups; one group said they believed homosexuality was a mental illness and one did not. Each group then read the fake studies full of pretend facts and figures suggesting their worldview was wrong. On either side of the issue, after reading studies which did not support their beliefs, most people didn’t report an epiphany, a realization they’ve been wrong all these years. Instead, they said the issue was something science couldn’t understand. When asked about other topics later on, like spanking or astrology, these same people said they no longer trusted research to determine the truth. Rather than shed their belief and face facts, they rejected science altogether.

In my view most people are “conditioned” to a set of political beliefs over time. The conditioning happens through the interaction of individual effort and experience and external stimuli. The process is path dependent.

If I am an entrepreneur, and I labor diligently for years to build my business and become wealthy and successful, I am conditioned to believe market systems work and are fair in allocating resources. I am more likely to support light regulation and promote individual accountability.

Likewise if I grow up in a community where financial institutions operate with predatory business models, I am conditioned to believe market systems are broken, and that a wealthy few (say, 1% of the population) manipulate markets to strip assets and wealth from communities like mine. I am more likely to support tight regulation and institutional accountability.

These are overly simplistic examples but I find them instructive. For someone like me who believes most individuals act based on incentive structures and not based on rational analysis, this is a powerful idea. It is consistent with the historical institutionalist approach to history, but on an individual level.

From Wikipedia:

A related crux of historical institutionalism is that temporal sequences matter: outcomes depend upon the timing of exogenous factors (such as inter-state competition or economic crisis) in relation to particular institutional configurations (such as the level of bureaucratic professionalism or degree of state autonomy from class forces).[6] For example, Theda Skocpol suggests that the democratic outcome of the English Civil War was a result of the fact that the comparatively weak English Crown lacked the military capacity to fight the landed upper-class. In contrast, the rise of rapid industrialization and fascism in Prussia when faced with international security threats was because the Prussian state was a “highly bureaucratic and centralized agrarian state” composed by “men closely ties to landed notables”.[7] Thomas Ertman, in his account of state building in medieval and early modern Europe, argues that variations in the type of regime built in Europe during this period can be traced to one macro-international factor and two historical institutional factors. At the macro-structural level, the “timing of the onset of sustained geopolitical competition” created an atmosphere of insecurity that appeared best addressed by consolidating state power. The timing of the onset of competition is critical for Ertman’s explanation. States that faced competitive pressures early had to consolidate through patrimonial structures, since the development of modern bureaucratic techniques had not yet arrived. States faced with competitive pressures later could on the other hand, could take advantage of advancements in training and knowledge to promote a more technical oriented civil service.[8][9]

The obvious takeaway from all of this is shouting at people about politics, either in person or on social media, is a complete waste of time and energy. Beyond that, however, this provides an objective framework for understanding why people believe certain things and why people behave in certain ways. This is of critical importance to investors, who must account for higher order, non-linear effects when making decisions.

Barring an “impact investing” mandate, an investor must set her political beliefs aside when making decisions. Rather the investor must focus on the beliefs of others. It is the beliefs of others that impact the economic and market environment.

The Hard Sell

“Mnuchin warns of equities fall without tax reforms”

One of the commenters says it best: “This is the hard sell on tax reform??”

This is just the latest example of how financial market performance has turned from output to input for policymakers in recent years. Granted, Mnuchin’s comment is more political propaganda than policy prescription. It’s worse at the Fed. At the Fed, preemptive strikes on market volatility have become standard operating procedure.

From Chris Cole’s excellent research piece, “Volatility and the Allegory of the Prisoner’s Dilemma” (linked above):

Pre-emptive central banking is a very different concept than the popular idea of the “central bank put”. The classic “central bank put” refers to policy action employed in response to, but not prior to, the onset of a crisis. Rate cuts in 1987, 1998, 2007-2008, and Quantitative Easing I and II (“QE”) programs were a response to weak economic data, elevated financial stress, and large drawdowns in credit and equity markets. To differentiate, pre-emptive central banking refers to monetary action in anticipation of future financial stress to avert a market crash before it starts,even if markets appear healthy and volatility is low. In executing a pre-emptive strike on risk, policymakers rely on changes in faster moving market data (e.g. 5yr-5yr breakeven inflation) rather than slower moving fundamental economic data (e.g. CPI and unemployment). Although well-intentioned, their actions have created dangerous self-reflexivity in markets by artificially suppressing volatility and encouraging rampant moral hazard. Central banks have exchanged ‘known unknowns’ for ‘unknown unknowns’ creating the potential for dangerous feedback loops. A central bank reaction function is now fully embedded in risk premiums. Markets are pricing the supportive policy response before action is even taken. Bad news is good news and vice versa because the intervention is more important than fundamentals. Pre-emptive strikes on risk are contributing to the massive growth and popularity of any asset or strategy with a short convexity or mean reversion return profile. The unintended consequences of this massive short convexity complex will be born from phantom liquidity, shadow gamma, and self-reflexivity.

Anyway, Mnuchin’s comments have nothing to do with tail risk. He is just beating the unwashed masses with a stick to keep pressure on Congress to deliver juicy tax cuts.

This is classic dumb money messaging. You know it’s dumb money messaging because it focuses on market prices and not valuations (traders and arbitrageurs should consider themselves exempt from my nasty sarcasm by definition). Hard selling works well with dumb money because dumb money doesn’t understand how cognitive and emotional biases impact financial decision making, or how to formulate capital market expectations. Mnuchin is basically saying to Average Joe, “if tax cuts don’t go through your 401(k) is going to crater.” That’s the true message and the true target.

See also: literally every penny stock promotion. Or the movie Boiler Room.

Something To Lose Sleep Over

Perhaps the scariest academic paper I have ever read is from a fellow named Marvin Goodfriend. Dr. Goodfriend is a professor of economics and a former Fed Research Director. His paper is titled “The Case For Unencumbering Interest Rates At The Zero Bound”. The reason this paper frightens me is that Dr. Goodfriend’s suggested methods for implementing negative interest rate policies are as follows:

1) Abolish paper currency (replace it with electronic currency)

2) Allow the value of paper currency to float (similar to the way that money market net asset values float)

3) Provide electronic currency alongside paper currency

The mechanisms may vary but the end is the same: the goal is to empower the central bank (in this case the Federal Reserve) to confiscate the cash savings of individuals to implement — at least in the Fed’s view — a more perfect form of monetary policy. Goodfriend views the zero bound on interest rates as an arbitrary constraint on Ever Wise & Enlightened Central Bankers’ policy toolbox, same as the gold standard. Of the gold standard, he writes:

The gold price of goods was determined by a variety of forces impacting the supply and demand for gold such as cost conditions in gold mining, the demand for jewelry, industrial demand, and the strength of economic growth underpinning the demand for money and its required gold backing. Fluctuations in any of the underlying determinants of the gold price of goods would feed into the price level under the gold standard.

Central banks worked increasingly during the 20th century to offset the influence of gold flows on their respective price levels. Central banks forced to buy gold at the pegged money price of gold sterilized the goal inflows, effectively raising their gold reserve ratios against currency and deposits, rather than allowing the gold inflows to generate inflationary growth of the money supply. Such behavior raised the world demand for gold, depressed the gold price of goods, and created global deflation pressure. Those countries losing gold, and thereby under pressure to deflate their domestic money supplies and price levels, chose instead to reduce minimum required gold reserves against currency and deposits, to impose direct controls of one sort or another, or to devalue their currencies in terms of gold. The gold standard was finally abandoned in the early 1970s so that fluctuations in the gold price of goods could be reflected in the money price of gold without destabilizing the general price level.

Similarly, the zero bound for interest rates impedes central banks’ ability to exercise complete control over monetary policy. The paper explains this through the use of a model (I am not much of a macro guy so I will not delve into the derivation of the model here). The plain language translation is that in making consumption choices households weigh whether it is better to spend to consume goods and services now or to save to consume goods and services later. In a deflationary environment households will hoard cash in hopes of spending later at lower prices. This creates a vicious, self-reinforcing cycle that sends prices, wages and economic output on a downward spiral.

To counteract this negative feedback loop the Ever Wise & Enlightened Central banker would impose a negative interest rate. That is, there would be an explicit cost attached to saving and an explicit payment attached to borrowing. Rather than earn interest on your savings account, you would pay interest on it. Rather than pay interest on your mortgage, the bank would pay you for borrowing.

Up is down. Black is white. If you are an academic economist I suppose this is all well and good. You swap some terms around in a model, develop a policy position and then implement it. If you are a real person — you know, the kind who has to make “real” decisions about saving versus spending — this sounds completely insane.

People may be dumb but they are not stupid. No one is going to say “gee, interest rates are negative, I should spend all of my money to avoid this tax on my savings, The Ever Wise & Enlightened Central Bankers will make sure everything works out in the end.” It is self-evident that if a negative interest rate policy ends up being effective, inflation will eventually return and interest rates will shift back into positive territory.

So what people will end up doing is hoarding assets anyway. Now they may not hoard actual cash (if Dr. Goodfriend has anything to say about it central banks will be able to delete units of currency at will). They will find some other asset to hoard though. Gold, silver, Bitcoins. Another thing people might end up saying is, “gee, interest rates are negative and appointed central bank officials with no direct accountability are confiscating my wealth. Maybe it is time for a change in political system.” A friend of mine calls this “villagers with pitchforks risk.”

Central bankers suffer from a collective delusion of control. It is evident when you hear Janet Yellen saying that we are unlikely to experience another financial crisis in our lifetimes, or when Mario Draghi brags about the ECB having neutralized tail risks (something that is by definition impossible). This is no different than tech stock investors claiming earnings no longer mattered in the late 1990s, or structured credit salespeople claiming home prices would never fall all at the same time circa 2005.

Be afraid.

A Fearful Symmetry

Tyger Tyger, burning bright,
In the forests of the night;
What immortal hand or eye,
Could frame thy fearful symmetry

– William Blake, “The Tyger”

Fidelity’s Abigail Johnson is in the FT today talking up fulcrum fees. Apparently Fidelity recently announced they would be launching a number of new mutual fund share classes with a fulcrum fee structure (details TBC). Here is Ms. Johnson:

Asset managers have typically charged a flat fee for active management. Most clients understand that even the best managers suffer some periods of underperformance measured over the long term.

Fulcrum fees would align the asset manager’s interests with those of the asset owner and encourage investors to remain committed to active strategies through the natural fluctuations in short-term performance

But is a flat fee fair, regardless of the value that is being delivered? Too often this model leaves us open to accusations of overcharging for mediocre performance. In a world increasingly dominated by index funds that allow cheap access to markets this is clearly unjustifiable. “Performance fees” are even more egregious. On top of the base fee, they add further charges when the manager does well — heads we win, tails you lose.

We need a fundamental rethink of the way asset managers charge their clients. Fulcrum fees have been used in the US since the 1970s — charges that rise when the fund outperforms, but fall by the same amount when the fund underperforms. Simple.

An important thing to remember is that it is generally not permitted under the Investment Company Act of 1940 for a mutual fund manager to charge a performance fee (e.g. the 2 & 20 structure common to hedge funds and private equity). If it were allowed, everyone would do it. Trust me.

However, the 1940 Act does allow symmetrical performance-based fees. In this structure, if the fund is outperforming its benchmark the manager’s fee is adjusted upward as a reward, while if the fund underperforms its benchmark it will be adjusted downward as a penalty. Later in her editorial Ms. Johnson acknowledges that despite being on the books for decades, this is not a popular compensation structure.

No kidding.

This is a classic issue of incentives. Fulcrum fees are bad juju for a lot of asset management businesses. Some old-but-good Vanguard data will show you why:

So according to this study, in a fulcrum fee arrangement 97% of these funds are going to get whacked with a performance penalty for a minimum of five years over any arbitrarily long time horizon. Meanwhile, if you stick with a flat fee based on assets under management you are guaranteed to collect your full management fee 100% of the time.

So why is one of the world’s largest asset managers now championing the structure?

My $0.02:

Investors are probably more cost conscious now than they have ever been. This is partly a function of academic research on the impact of expenses on investment results, but more so because investors have access to a proliferation of cheap investment alternatives (note: cheap does not necessarily equal better, though for the time being it seems most people are treating the two as synonymous).
Add to the above the fact that a lot of active funds aren’t as active as you might think.
On a totally anecdotal level, I would say investors are more aware of issues around conflicted advice as relates to investment manager compensation than they have been historically. Personally I attribute a lot of that to the internet and the number of professional and personal blogs devoted to personal finance and investing.

Fidelity isn’t run by idiots. In my view they are making the smart play. Better to get out in front and position yourself on the leading edge of investor-friendly compensation structures. It gives you some initiative in dealing with the business impact and will also provide some marketing ammunition, like investor-friendly editorials in the FT. Vanguard has been doing this for decades now and it has paid off in spades. I know this all sounds rather cynical but remember we are talking about trillions of dollars in mutual fund assets that are perpetually up for grabs.

Now over to William Blake for a pithy conclusion:

When the stars threw down their spears
And water’d heaven with their tears:
Did he smile his work to see?
Did he who made the Lamb make thee?

Tyger Tyger burning bright,
In the forests of the night:
What immortal hand or eye,
Dare frame thy fearful symmetry?

Empires & Barbarians

Peter Heather’s Empires And Barbarians is a book worth reading. Unfortunately it is also a book that is difficult to recommend. It is written for an academic audience. Which is another way of saying it can make for incredibly dry reading. This is a shame in that the scholarship, the ambition and the quality of Heather’s arguments are all impressive.

The central idea is this: in the beginning there is agriculture. Primitive agriculture is hard. It consumes a great deal of time and energy and leaves very little time for anything else. Life is nasty, brutish and very short.

What societies need to develop beyond a relatively miserable subsistence level agriculture is specialization.

This can happen in a couple of different ways. One way (the slow way) is that agricultural societies gradually develop technology that makes farming more efficient and less time intensive. This allows certain members of the community to focus on other activities — perhaps the manufacture of consumer goods, or the development of systems of writing (if this process interests you I highly recommend Jared Diamond’s Guns, Germs, and Steel: The Fates of Human Societies). As specialization increases people’s lives tend to get a little less nasty, a little less brutish and a little bit longer.

Another, faster way that development happens is via trade and migration. For example, of early Germanic societies, Heather writes:

In the case of the Germani, Rome may have acted as a source not only of extra economic demand, but also possibly for some of the ideas and technology that made agricultural intensification possible […]

[…] Where and how, exactly, these ideas spread remains to be studied, but both the more efficient ploughs and the better integrated farming regimes were well known in Roman and La Tene Europe, much of which the Empire swallowed up in the first century BC, long before they spread into Germania, and and these areas may have inspired the Germanic agricultural revolution.

Other goods produced in Germania were also in demand in the Roman world. The occasional loan word and literary reference identify some specific products. Goose feathers for stuffing pillows and particular kinds of red hair dye were two such items. Much more important than any of these, though, was the demand certainly for two, and probably three, other raw materials.

Empires And Barbarians is more or less a case study of migration and development in the context of Europe in the first century AD. What I take away from the book is not so much the details, but the timeless nature of the process.

For example, in the fourth and fifth centuries the arrival of the Hunnic Empire in Europe caused enormous political and social dislocations. In essence, displaced barbarians showed up on the Roman Empire’s doorstep. For a whole series of complex reasons, not least of which was the need to bolster Roman Legions with barbarian manpower, the Romans were sometimes forced to grant concessions.

In a general sense, this is not so much different from what we see in Europe today with the mass influx of refugees from the Middle East, North Africa and South Asia. Or in the United States with refugees and migrants from Central and South America.

Again, Heather:

[I]t is important to factor in the general patterns of economic development operating in and around the Roman world. The Goths and other Germanic migrants of the third century had moved into the Black Sea region because it was part of a more developed inner periphery around the Roman Empire, with many economic attractions. And while these migrants were benefiting from that greater wealth, the Roman Empire was operating at a still higher level of development, with still greater economic surpluses. This wealth was immediately visible to outsiders in the Empires frontier zones in the form of towns, fortifications, armies, even villas, all of which, as we have seen, regularly attracted cross-border raiders. Ammianus’ account of Gothic motives, — that Roman wealth had entered their calculations — makes perfect sense, therefore, and also recalls modern case studies, where it is rare for economic motivations to be absent from immigrants’ calculations, even when their thinking has a strong element of the political and involuntary about it.

What I think is often missed in the debate surrounding immigration and refugee policy is this “zoomed-out” perspective of trade, migration and development. This is not some series of isolated incidents that can simply be prevented or outlasted. It is a cyclical process underpinning the evolution of human civilization. You don’t “beat” these kinds of cycles any more than you “beat” waves in the ocean.

So why does this get missed?

The news cycle plays out in hours. Election cycles play out in months and years. Economic cycles play out over decades. These cycles of migration and development play out over multi-decade, multi-generational time horizons. They create winners and losers.

People do not like to spend even half a lifetime losing. They will do seemingly crazy things to stop losing — to have a shot at winning. They will vote dictators into power. They will support ill-advised wars of aggression. They will wander thousands of miles on foot and pay thousands of dollars to criminals to ferry them across oceans in what are more or less bathtubs.

The value of a history like Empires And Barbarians, dry as it may read at times, is that it can afford to take the very, very long view. A luxury we cannot often afford.

Gazprom vs. Sanctions

In the interest of full disclosure, I am long Gazprom ADRs. This post is written for entertainment purposes only and is not a recommendation to buy or sell any Gazprom-related security. Readers should consult a financial advisor before buying or selling any security. An advisor will be able to make a recommendation while taking the investor’s unique circumstances into consideratiom. Now, on to the show…

Hear that frenetic popping sound? Kind of like a firing squad executing a an opposition politician? Actually it is the sound of the Russian oligarchy uncorking champagne. Gazprom, Russia’s state-owned gas company, was recently ranked #1 in the 2017 S&P Global Platts Top 250 Global Energy Company Rankings, dethroning reigning champion Exxon Mobil.

Gazprom is a fascinating entity for any number of reasons. Chief among them is that it is majority controlled by the Russian state, is a behemoth of an integrated oil and gas company and is therefore an instrument of Russian geopolitical strategy. Here are some fast facts from the 2016 Annual Report:

There is common misconception in the United States that sanctions on Russia somehow really matter. And sure, they matter at the margins. Certainly if you are a Russian oligarch they may impede your ability to make extravagant purchases. Sanctions make it harder and more expensive for Russian companies to do certain things. Project finance wrangling in particular can be a pain.

But remember – Russia via Gazprom controls nearly 20% of global gas reserves and maintains a relatively low cost position. This is something of an economic moat and if you are Russia/Gazprom it gives you options. For example, running export pipelines into China, and developing a liquefied natural gas (LNG) export hub in proximity to Southeast Asia.

It is hardly a coincidence that in 2016 Gazprom closed a EUR 2 billion credit facility with the Bank of China (the 2016 Annual Report trumpets this as “The largest deal in the Company’s history in terms of the amount of financing attracted directly from one financial institution”). The company also held investor day events in both Singapore and Hong Kong earlier in 2017. Why? Per a Gazprom press release:

The region is of strategic importance for Gazprom’s development. The Company aims to foster an increased cooperation with its Asian partners and strives to diversify its investor pool and financing sources, with a primary focus on Asia-Pacific’s potential. Specifically, 52 per cent of the Company’s loans in 2016 were provided by Asian banks, which shows that they have a high level of confidence in Gazprom.

Translation: “Ready access to Asian capital markets allows us to reduce our dependence on US and European companies and institutions for financing, just in case we lose access to western capital.”

So here is a lesson in incentives: trade restrictions like sanctions will only bite insofar as no one of means has a strong incentive to violate them. Otherwise someone or some entity is going to come in and arbitrage those restrictions. Critically, ideological incentives do not count. History is replete with examples of people and entities abandoning entrenched ideological positions when it will benefit them economically. In many cases, simple greed will do the trick.

This old Bronte Capital post provides an elegant historical example:

A typical Marc Rich & Co trade involved Iran (under the Shah), Israel, Communist Albania and Fascist Spain. The Shah needed a path to export oil probably produced in excess of OPEC quotas and one which was unaudited and hence could be skimmed to support the Shah’s personal fortune. Israel – a pariah state in the Middle East – wanted oil. Spain had rising oil demand and limited foreign currency but was happy to buy oil (slightly) on the cheap. Spain however did not recognise Israel and hence would not buy oil from Israel – so it needed to be washed through a third country. Albania openly traded with both Israel and Spain. Oh, and there is an old oil pipeline which goes from Iran through Israel to the sea.

So what is the deal? The Shah sells his non-quota oil down the pipeline through Israel and skims his take of the proceeds. Israel skim their take of the oil. Someone doing lading and unlading in Albania gets their take and hence make it – from the Spanish perspective – Albanian, not Israeli oil. The Spanish ask few questions. The margins are mouth-watering – and they all come from giving people what they really want rather than what they say they want. We know what the Shah wanted (folding stuff). We know what Israel wanted (oil). We know what Spain wanted (cheap oil). Who cares that Spain was publicly spouting anti-Israel rhetoric. [Similar trades allowed South Africa to break the anti-Apartheid trade embargoes.]

[…]And when the Shah fell? Oh well – Pincus Green – an American Jewish businessman – gets on the plane to Iran and does a similar deal with the Mullahs – who – despite their rhetoric will sell oil down a pipeline through Israel – and will allow Israel to skim their take. Trading through the American embargo – well that is just another instance of getting around restrictions and profiting (very) handsomely.

The Gazprom-China relationship isn’t nearly as complex as these Marc Rich & Co. transactions. China has not agreed to the sanctions regime imposed on Russia by western countries. China and the rest of developing Asia simply need cheap and abundant supplies of natural gas. Gazprom is able to meet that need, and will be happy to have the Chinese as a source of project finance.

The political kerfuffle surrounding Gazprom’s Nord Stream 2 pipeline in Europe revolves around similar dynamics. Eastern European states such as Poland, Latvia, Lithuania and Estonia rightly fear dependence on Russian gas as it gives Russia powerful leverage over their economies and therefore their political independence. German industry, meanwhile, would much prefer cheap Russian pipeline gas to more expensive LNG imports.

While today’s headlines herald booming US LNG exports, independent research implies US exports will eventually need to price significantly higher to cover producers’ full marginal costs (including capex, liquefaction & shipping — after all it is not cheap to send tankers full of LNG halfway around the world):

So again economic incentives outweigh any warm and fuzzy notion of European solidarity. The result is a running trade case that has been winding its way through the EU bureaucracy for years.

And meanwhile the Nord Stream pipeline project grinds on…