July 2015 – Page 2 – The Aleph Blog

How To End Index Gaming

Posted on 11 July 201512 July 2015 by David Merkel

There was an article at Bloomberg on gaming additions to and deletions from indexes, and at least two comments on it (one, two). ?You can read them at your convenience; in this short post I would like to point out two ways to stop the gaming.

Define your index to include all securities in the class (say, all US-based stocks with over $10 million in market cap), or
Control your index so that additions and deletions are done at your leisure, and not in any predictable way.

The gaming problem occurs because index funds find that they have to buy or sell stocks when indexes change, and more flexible investors act more quickly, causing the index funds to transact at less favorable prices. ?You never want to be in the position of being forced to make a trade.

The first solution means using an index like the Wilshire 5000, which in principle covers almost all stocks that you would care about. ?Index additions would happen at things like IPOs and spinoffs, and deletions at things like takeovers — both of which are natural liquidity events.

Solution one would be relatively easy to manage, but not everyone wants to own a broad market fund. ?The second solution remedies the situation more generally, at a cost that index fund buyers would not exactly know what the index was in the short-run.

Solution two destroys comparability, but the funds would change the target percentages when they felt it was advantageous to do so whether it was:

Make the change immediately, like the flexible investors do, or
Phase it in over time.

And to do this, you might ask for reporting waivers from the SEC for up to x% of the total fund, whatever is currently in transition. ?The main idea is this: you aren’t forced to trade on anyone else’s schedule. ?The only thing leading you would be what is best for your investors, because if you don’t do well for them, they will leave you.

Now, that implies that if you were to say that your intent is to mimic the S&P 500 index, but with some flexibility, that would invite easy comparisons, such that you would?be less free to deviate too far. ? But if you said your intent was more akin to the Russell 1000 or 3000, there would be more room to maneuver. ?That said, choosing an index is a marketing decision, and more people want the S&P 500 than the Wilshire 5000, much less the US Largecap Index.

So, maybe with solution two the gaming problem isn’t so easy to escape, or better, you can choose which?problem you want. ?Perhaps the one bit of practical advice here then is to investors — choose a broad market index like the Wilshire 5000. ?At least your index fund won’t get so easily gamed, and given the small cap effect over time, you’ll probably do better than the S&P 500, even excluding the effects of gaming.

There, a simple bit of advice. ?Till next time.

Asset-Liability Mismatches and Bubbles

Posted on 9 July 2015 by David Merkel

There’s a lot of talk about the Chinese stock market falling. I look at it as an opportunity to talk about why bubbles develop in markets, and why governments don’t take steps to avoid them until it is too late — also, why they try to prop the bubbles up, even though it is hopeless. ?But first an aside:

Three weeks ago, I was interviewed on RT/America Boom/Bust. ?Half of the interview aired — the part on domestic matters. ?The part on Greece and China didn’t air, and what a pity. ?I argued that China today was very much like Japan in the late ’80s, where the Japanese had a hard time investing abroad, and had an expansive monetary policy. ?People had a hard time figuring out where to put their money. ?Savings and fixed income didn’t offer much. ?Real Estate was great if you could afford it. ?The stock market was a place for putting money to work — and it had a lot of momentum behind it.

China has the added complexity of wealth management products which are opaque and many are Ponzi schemes. ?Also, the fixed income markets in China are not as mature as Japan’s markets 30 years ago. ?Both have the difficulties that they are too big for some of the indexes that international investors use.

Another reason for the bubbly behavior was use of margin, both formal and informal, and, the tendency for stock investors to have very short holding periods. ?Short-termism and following momentum is most of what creates bubbles. ?Ben Graham’s voting machine dominates, until the weighing machine takes over, and the voting machine votes the opposite way.

Long term assets like stocks should be financed with equity, or at worst, long-term debt. ?Using a lot of margin debt to finance equity leads to a rocket up, and a rocket down. ?When the amount of equity in the ?account gets too low, more assets have to be added, or stocks will have to be liquidated to protect the margin loan that the broker made. ?When enough stocks in margin accounts are forced to be sold, that can drive stock prices down, leading to a self-reinforcing cycle, until the debt levels normalize at much lower levels. ?This is a part of what happened in the Great Depression in the US.

Now governments never argue with bubbles when they expand, because no one dares to oppose a boom. ?(Note: that article won a small award. Powerpoint presentation here.) ?The powers that be love effortless prosperity, and no one wants to listen to a prophet of doom when the Cabaret is open.

Now, the prosperity is mostly?fake, because all of the borrowing is temporarily pulling future prosperity into the present. ?When the bubble pops, that will revert with a vengeance, leaving behind bad debts.

Despite the increase in debts, and speculative changes in economic behavior, most policymakers will claim that they can’t tell whether a bubble is growing or not. ?Their bread is buttered on the side of political contributions from financial firms.

But when the bubble pops, and things are ugly, governments will try to resist the deflating bubble — favoring relatively well-off asset owners over not-so-well-off taxpayers. ?In China at present, they are closing down markets for stocks (if it doesn’t trade, the price must not be falling). ?They are trying to be more liberal about liquidating margin debt. ?They are limiting share sales by major holders. ?They are postponing IPOs. ?They are inducing institutions to buy stock.

China thinks that it can control and even reverse the deflating bubble. ?I think they are deluded. ?Yes, they are relatively more powerful in their own country than US regulators and policymakers. ?But even if their institutions were big enough to suck up all of the stock at existing prices, it would merely substitute on problem for another: the institutions would be stuck with assets that have?low forward-looking returns. ?If you use those to fund a defined benefit pension plan, you will likely find that you have embedded a loss in the plan that will take years to reveal itself.

As a result, since China is much larger than Greece, its problems get more attention, because they could affect the rest of the world more. ?For Western investors without direct China exposure, I’m not sure how big that will be, but with highly valued markets any increase in volatility could cause temporary indigestion.

The one bit of friendly advice I might offer is don’t be quick to try to catch a falling knife here. ?It might be better to wait. and maybe buy stocks in countries that get unfairly tarred by any panic coming out of China, rather than investing in China itself. ?Remember, margin of safety matters. ?More on that coming in a future post.

Avoid Indexed Life Insurance Products

Posted on 8 July 2015 by David Merkel

Everyone reading should know that I am an actuary, as well as a quant and a financial analyst. ?Math is my friend.

Math is not the friend of many of my readers, so I usually don’t bother them with the math. ?Tonight’s post will be no different. ?It stems from my time of creating investment strategies for what was at that time a leading indexed annuity seller.

What is the return that you get from an indexed annuity? ?It is the return from index options, subject to a certain minimum return over a 7-15 year period. Now, on average, what is the return you get from buying any fairly priced option? ?You get the return on T-bills plus zero to a slight negative percentage. ?So, if the option premiums paid are cumulatively greater than the guaranteed minimum return, the product should return more than the minimum on average — but likely not much more on average.

Why is that? ?Options are a zero sum game, and usually there is no inherent advantage to the buyer or seller. ?There are some exceptions to this rule, but it favors at-the money option sellers, never buyers.?Buying options is what happens with?indexed annuity products.

Now, over any short amount of time, like 5-10 years, you can get very different results than the likely average. ?That doesn’t affect my point. ?With games of chance, some get get good outcomes, and other get bad outcomes.

Now, the indexed product sellers will tell potential buyers that they will never lose money if the market goes down. ?True enough. ? What they don’t tell you is that over the long haul, you will most likely earn more investing in one of Vanguard’s S&P 500 funds or even their Balanced Index Fund. ?You may even earn more investing in their high yield fund, or even their bond market index fund.

In exchange for eliminating all negative volatility, you end up getting very modest interest credits, while still being exposed to the credit risk of the insurance company. ?In an insolvency, your policy will be affected. ?The state guaranty funds will likely protect you if your policy is underneath the coverage limits, but still it is a bother.

Add to that the illiquidity of the product. ?Yes, you can cash it in at any time, do 1035 exchanges, etc., but before the end of the surrender charge period you will pay a fee that compensates the insurance company for the amortized value of the large commission that they paid the agent that sold you the policy. ?For most people, the surrender charge psychologically locks them in.

Thus I say it is better to be disciplined, and buy and hold a volatile investment with low fees over time, rather than own an indexed annuity that will tend to lock you in, and deliver lower returns on average. ?That’s all, aside from the postscript.

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Postscript

How does an insurance company make a profit on an indexed annuity? ?They take the proceeds of the sale, pay the agent, and use the rest to invest. ?About 90% of the money will be invested in a bond that will cover the minimum guarantee. ?The remainder will buy option premiums — the amount of money that gets applied to that is close to the credit spread on the bonds less the insurance company’s fees to pay the costs of the company and?a charge for profit. Not a lot is typically left in a low yield environment like this. ?The company tries to buy the most attractive options that they can on a limited budget. ?Inexpensive options typically imply that most will finish out of the money, and/or when they do finish in-the-money, the rewards won’t be that large.

Sixteen Implications of “The Phases of an Investment Idea”

Posted on 2 July 2015 by David Merkel

My last post has many implications. I want to make them clear in this post.

When you analyze?a manager, look at the repeatability of his processes. ?It’s possible that you could get “the Big Short” right once, and never have another good investment idea in your life. ?Same for investors who are the clever ones who picked the most recent top or bottom… they are probably one-trick ponies.
When a manager does well and begins to pick up a lot of new client assets, watch for the period where the growth slows to almost zero. ?It is quite possible that some of the great performance during the high growth period stemmed from asset prices rising due to the purchases of the manager himself. ?It might be a good time to exit, or, for shorts to consider the assets with the highest percentage of market cap owned as targets for shorting.
Often when countries open up to foreign investment, valuations are relatively low. ?The initial flood of money in often pushes up valuations, leads to momentum buyers, and a still greater flow of money. ?Eventually an adjustment comes, and shakes out the undisciplined investors. ?But, when you look at the return series analyze potential future investment, ignore the early years — they aren’t representative of the future.
Before an academic paper showing a way to invest that would been clever to use in the past gets published, the excess returns are typically described as coming from valuation, momentum, manager skill, etc. ?After the paper is published, money starts getting applied to the idea, and the strategy will do well initially. ?Again, too much money can get applied to a limited factor (or other) anomaly, because no one knows how far it can get pushed before the market rebels. ?Be careful when you apply the research — if you are late, you could get to hold the bag of overvalued companies. ?Aside for that, don’t assume that performance from the academic paper’s era or the 2-3 years after that will persist. ?Those are almost always the best years for a factor (or other) anomaly strategy.
During a credit boom, almost every new type of fixed income security, dodgy or not, will look like genius by?the early purchasers. ?During a credit bust, it is rare for a new security type to fare well.
Anytime you take a large position in an obscure security, it must jump through extra hoops to assure a margin of safety. ?Don’t assume that merely because you are off the beaten path that you are a clever contrarian, smarter than most.
Always think about the carrying capacity of a strategy when you look at an academic paper. ?It might be clever, but it might not be able to handle a lot of money. ?Examples would include trying to do exactly what Ben Graham did in the early days today, and things like Piotroski’s methods, because typically only a few small and obscure stocks survive the screen.
Also look at how an academic paper models trading and liquidity, if they give it any real thought at all. ?Many papers embed the idea that liquidity is free, and large trades can happen where prices closed previously.
Hedge funds and other manager databases should reflect that some managers have closed their funds, and put them in a separate category, because new money can’t be applied to those funds. ?I.e., there should be “new money allowed” indexes.
Max Heine, who started the Mutual Series funds (now part of Franklin), was a genius when he thought of the strategy 20% distressed investing, 20% arbitrage/event-driven investing and 60% value investing. ?It produced great returns 9 years out of 10. ?but once distressed investing and event-driven because heavily done, the idea lost its punch. ?Michael Price was clever enough to sell the firm to Franklin before that was realized, and thus capitalizing the past track record that would not?do as well in the future.
The same applies to a lot of clever managers. ?They have a very good sense of when their edge is getting dulled by too much competition, and where the future will not be as good as the past. ?If they have the opportunity to sell, they will disproportionately do so then.
Corporate management teams are like rock bands. ?Most of them never have a hit song. ?(For managements, a period where a strategy improves profitability far more than most would have expected.) ?The next-most are one-hit wonders. ?Few have multiple hits, and rare are those that create a culture of hits. ?Applying this to management teams — the problem is if they get multiple bright ideas, or a culture of success, it is often too late to invest, because the valuation multiple adjusts to reflect it. ?Thus, advantages accrue to those who can spot clever managements before the rest of the market. ?More often this happens in dull industries, because no one would think to look there.
It probably doesn’t make sense to run from hot investment idea to hot investment idea as a result of all of this. ?You will end up getting there once the period of genius is over, and valuations have adjusted. ?It might be better to buy the burned out stuff and see if a positive surprise might come. ?(Watch margin of safety…)
Macroeconomics and the effect that it has on investment returns is overanalyzed, though many get the effects wrong anyway. ?Also, when central bankers and politicians take cues from the prices of risky assets, the feedback loop confuses matters considerably. ?if you must pay attention to macro in investing, always ask, “Is it priced in or not? ?How much of it is priced in?”
Most asset allocation work that relies on past returns is easy to do and bogus. ?Good asset allocation is forward-looking and ignores past returns.
Finally, remember that some ideas seem?right by accident — they aren’t actually right. ?Many academic papers don’t get published. ?Many different methods of investing get tried. ?Many managements try new business ideas. ?Those that succeed get air time, whether it was due to intelligence or luck. ?Use your business sense to analyze which it might be, or, if it is a combination.

There’s more that could be said here. ?Just be cautious with new investment strategies, whatever form they may take. ?Make sure that you maintain a margin of safety; you will likely need it.