Day: July 12, 2014

Aiming for Transparency

Aiming for Transparency

Here’s another letter from a reader:

David,

I’m starting this fund, and I wanted to get your opinion.

?It is best explained on YouTube in 55 seconds: let me know what you think?https://www.youtube.com/watch?v=frwOrQd3f6w. It (hopefully) will provide incentive for transparency in funds.

?Thank you!

Okay, I can’t embed?the short video, so click on the link above and watch it — it is less than a minute, and well-done.

To the writer:

I admire your efforts at providing transparency here, but let me tell you where I think this may have unintended negative consequences.

Anytime you provide total transparency, you invite front-running, if the manager is any good. ?New ideas are often most potent at their beginning, and given the delay between notifying mutual fund shareholders, voting and implementation, critical time is sacrificed, and some of your shareholders may front-run you.

Imagine a person investing the minimum in your fund so that he could front-run your picks with a greater amount of money. ?But even if front-running does not happen, it is generally wise to move rapidly once the manager has come to a decision. ?The delay from?having shareholders vote on it is likely a money-loser. ?Also during times of crisis, the manager may have some of his best ideas, but when average people are scared, will they be willing to pull the trigger? ?I have my doubts.

In general, I favor investment methods where decision-making is done by individuals. ?If I were running a hedge fund, or a large mutual fund, I would delegate all decisions to the sector/industry analysts. ?Let sharp opinions prevail. ?I’ve worked in areas where groupthink muddies investment decisions — it does not lead to outperformance.

Transparency

You don’t need to have shareholders vote on investments to have transparency. ?You could do what I do, because all of my investors have full transparency.

I manage separate accounts using Interactive Brokers. ?We buy and sell as a group. ?We all get the same buy and sell prices. ?I don’t trade often, but any investor can monitor his/her account all day long. ?They can set up a daily download so that they can see what actions have been taken, if any. ?There is total transparency, to the degree that my investors want to make the effort. ?And remember, making investors go through a lot of effort is a negative.

If I Were in Your Shoes

If I wanted to give your investors transparency, I would give them access to a website showing the portfolio in real time, set up in such a way that only they could see it. ?I would not let them vote on investments. ?If you are hiring a manager, let him manage. ?Second-guessing and delay are a waste of time and money.

Now those are my thoughts, and maybe your views on running a democratic fund are important to you. ?Do what you think is best — just remember that democracy is not the same as transparency, and to achieve transparency, democracy is not needed. ?Information is power, and you want to be careful in how you share it.

All that said, I hope you succeed, and that it works out well for you and your shareholders!

One More Note on Failure

One More Note on Failure

Recently, we had a problem at the Merkel house: a toilet overflowed and the water did not shut off, flooding the room, and leaked into the basement. ?Why did this happen? ?Two things went wrong at the same time:

  1. The toilet needed to be plunged, because there was a blockage preventing water discharge, and
  2. The flapper malfunctioned, and so water continued to flow.

If only one of these problems had happened, we would have had an ordinary problem. ?I can plunge a toilet, easy. ?I can hear the toilet singing, and know that the flapper is up, jiggle the handle, and end the problem.

Most of the time, when we plan against failure, we look at solutions that address single failures. ?We do not contemplate two things going wrong at once.

Yet, when we look at big failures in investment, there are often?two things that went wrong at the same time. ?Usually it follows a pattern like this:

  1. Take a risk that in ordinary times often works out, but
  2. You don’t get that times are not ordinary, and so the odds are actually stacked against you.

I have several examples for this. ?Taking on debt to buy a house was a wonderful strategy until overall debt levels to finance housing got to high, but at that time, the momentum effect of rising house prices was sucking people into buying houses, because they thought it was easy money.

Financial stocks were the market leaders for many years up through 2007, as investors assumed that ordinary risk control would protect the banking system. ?But what happens when debt levels are too high, so that many debts are incapable of being paid?

As Warren Buffett has said (something like), “We get paid to think about the things that can’t happen.” ?Multiple failures leading to large bad results are worth thinking about. ?So what aren’t we thinking about now?

  • Failures in retirement security systems as the Baby Boomers age.
  • Failures in government debt as overleveraged governments can’t make debt payments.
  • Inflation rises rapidly as the economy revives amid increased lending from banks.
  • Deflation persists as the central?bank tries to force-feed credit to an already overleveraged economy.

(There are many patting themselves on the back thinking that the Central Banks and Governments got us out of a crisis, when they only delayed the crisis. ?High nominal debt levels relative to GDP create their own crisis.)

I would encourage you to think about your investments, and ask the following questions:

  • Are there hidden factors that could lead to a big failure? ?(Think of what happened to mortgage REITs in 2008 when the repo market crashed.)
  • How well would the investment?fare if inflation went up significantly?
  • How well would the?investment?fare if real interest rates?went up significantly?
  • How well would the?investment?fare if?we hit another patch where financing is not available? ?Can the investment self-fund?
  • How much future prosperity does the current price of the investment embed in its valuation?

I know, glum words. ?But this might be a good time to look at what you own, and ask how survivable it is under stressed conditions.

All for now.

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