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The Good ETF, Part 2 (sort of)

Friday, April 18th, 2014

About 4.5 years ago, I wrote a short piece called The Good ETF.  I’ll quote the summary:

Good ETFs are:

  • Small compared to the pool that they fish in
  • Follow broad themes
  • Do not rely on irreplicable assets
  • Storable, they do not require a “roll” or some replication strategy.
  • Not affected by unexpected credit events.
  • Liquid in terms of what they repesent, and liquid it what they hold.

The last one is a good summary.  There are many ETFs that are Closed-end funds in disguise.  An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.

Though I said ETFs, I really meant ETPs, which included Exchange Traded Notes, and other structures.  I remain concerned that people get deluded by the idea that if it trades as a stock, it will behave like a stock, or a spot commodity, or an index.

What triggered this article was reading the following article: How a 56-Year-Old Engineer’s $45,000 Loss Spurred SEC Probe.  Quoting from the beginning of the article:

Jeff Steckbeck didn’t read the prospectus. He didn’t realize the price was inflated. He didn’t even know the security he read about online was something other than an exchange-traded fund.

The 56-year-old civil engineer ultimately lost $45,000 on the wrong end of a volatility bet, or about 80 percent of his investment, after a Credit Suisse Group AG (CSGN) note known as TVIX crashed a week after he bought it in March 2012 and never recovered. Now Steckbeck says he wishes he’d been aware of the perils of bank securities known as exchange-traded notes that use derivatives to mimic assets from natural gas to stocks.

“In theory, everybody’s supposed to read everything right to the bottom line and you take all the risks associated with it if you don’t,” he said this month by phone from Lebanon, Pennsylvania. “But in reality, you gotta trust that these people are operating within what they generally say, you know?”

No, you don’t have to trust people blindly.  Reagan said, “Trust, but verify.”  Anytime you enter into a contract, you need to know the major features of the contract, or have trusted expert advisers who do know, and assure you that things are fine.

After all, these are financial markets.  In any business deal, you may run into someone who offers you something that sounds attractive until you read the fine print.  You need to read the fine print.  Now, fraud can be alleged to those who actively dissuade people from reading the fine print, but not to those who offer the prospectus where all of the risks are disclosed.  Again, quoting from the article:

Some fail to adequately explain that banks can bet against the very notes they’re selling or suspend new offerings or take other actions that can affect their value, according to the letter.

[snip]

“My experience with ETN prospectuses is that they’re very clear about the fees and the risks and the transparency,” Styrcula said. “Any investor who invests without reading the prospectus does so at his or her own peril, and that’s the way it should be.”

[snip]

The offering documents for the VelocityShares Daily 2x VIX (VIX) Short Term ETN, the TVIX, says on the first page that the security is intended for “sophisticated investors.” The note “is likely to be close to zero after 20 years and we do not intend or expect any investor to hold the ETNs from inception to maturity,” according to the prospectus.

While Steckbeck said a supervisor at Clermont Wealth Strategies advised him against investing in TVIX in February 2012, he bought 4,000 shares the next month from his self-managed brokerage account. The adviser, whom Steckbeck declined to name, didn’t say that the price had become unmoored from the index it was supposed to track.

David Campbell, president of Clermont Wealth Strategies, declined to comment.

Steckbeck, who found the TVIX on the Yahoo Finance website, doesn’t have time to comb through dozens of pages every time he makes an investment, he said.

“Engineers — we’re not dumb,” said Steckbeck, who founded his own consulting company in 1990. “We’re good with math, good with numbers. We read and understand stuff fairly quickly, but we also have our jobs to perform. We can’t sit there and read prospectuses all day.”

If you are investing, you need to read prospectuses.  No ifs, ands, or buts.  I’m sorry, Mr. Steckbeck, you’re not dumb, but you are foolish.  Being bright with math and science is not enough for investing if you can’t be bothered to read the legal documents for the complex contract/security that you bought.  I read every prospectus for every security that I buy if it is unusual.  I read prospectuses and 10-Ks for many simple securities like stocks — the managements must “spill the beans” in the “risk factors” because if they don’t, and something bad happens that they didn’t talk about, they will be sued.

In general I am not a fan of a “liberal arts” education.  I am a fan of math and science.  But truly, I want both.  We homeschool, and our eight kids are “all arounds.”  They aren’t all smart, but they tend to be equal with verbal and quantitative reasoning.  Truly bright people are good with both math and language.  Final quotation from the article:

“The whole point of making these things exchange-traded was to make them accessible to retail investors,” said Colbrin Wright, assistant professor at Brigham Young University in Provo, Utah, who has written academic articles on the indicative values of ETNs. “The majority of ETNs are overpriced, and about a third of them are statistically significant in their overpricing.”

So, I contacted Colby Wright, and we had a short e-mail exchange, where he pointed me to the paper that he co-wrote.  Interesting paper, and it makes me want to do more research to see how great ETN prices can be versus their net asset values [NAVs].  That said, end of the paper errs when it concludes:

We assert that the frequent and persistent negative WDFDs [DM: NAV premiums] that appear to be driven by uninformed return chasing investors would not exist to the conspicuous degree that we observe if ETNs offered a more investor-driven and fluid system for share creation. We believe the system for share creation is ineffective in mitigating the asymmetric mispricing investigated in our study. Hence, we recommend that ETN issuers reformulate the share creation system related to their securities. Specifically, we recommend the ETN share creation process be structured to mirror that of ETFs. At a minimum, the share creation process should be initiated by investors, rather than by the ETN issuers themselves, as we believe profit-motivated investors will be more diligent and responsive in creating ETN shares when severe mispricing arises.

Here’s the problem: ETNs are debt, not equity.  To have the same share creation system means that the debtor must be willing to take on what could be an unlimited amount of debt.  In most cases, that doesn’t work.

So I come back to where I started.  Be skeptical of complexity in exchange traded products.  Avoid complexity.  Complexity works in favor of the one offering the deal, not the one accepting the deal.  I have only bought one structured note in my life, and that was one that I was allowed to structure.  As Buffett once said (something like this), “My terms, your price.”

To close, here are four valuable articles on this topic:

So avoid complexity in investing.  Do due diligence in all investing, and more when the investments are complex.  I am astounded at how much money has been lost in exchange traded investments that are designed to lose money over the long term.  You might be able to avoid it, but someone has to hold every “asset,” so losses will come to those who hold investments long term that were designed to last for a day.

On a Concentrated Bond Market

Monday, April 14th, 2014

There have been a few articles recently on the underperformance of Pimco, and on the increasing concentration on the buy side of the bond market.  There is danger here for large active managers and their clients.

Two years ago, I wrote a piece called Don’t Become the Market.  Though the piece doesn’t talk about it, I wrote it partly to explain the “London Whale” problem of JP Morgan.  Anytime you become big relative to a market that you use, your own actions affect the prices of the market.  This means that a market dominated by a firm or set of firms pursuing a similar strategy will no longer be able to rely on prices as a reasonable guide in assessing risk.

Smaller players, who can trade without affecting prices, can still make their estimates of risk at current prices, and they can trade against larger players.  Though there are initially economies of scale, once you get big enough as an active investment manager, the diseconomies of scale kick in.

It is relatively easy to outperform when you are a small manager.  But when you get big as an active manager, you begin to find that you can’t find so many good investable ideas.  Now, if you were a passive manager like Vanguard, you wouldn’t have to worry — just own an even slice of everything, and complain that you don’t get a decent allocation on bond IPOs.

Because of this, I tend to use smaller managers for money that is not passively managed.  The smaller the manager, the more he can take advantage of off-the-beaten-track ideas.  If he is a trader (unlike me), being small is an advantage if he has skill.

There is an exception to this, and it is for institutions that buy and hold fixed income obligations.  In that case, holding 50% of the issue is not a problem if you’ve done your credit work right.  You have no intention of selling, and you will bear the few losses that you take.  If a large manager acts like that, it can work so long as its financing cannot run, and the defaults are not overwhelming.

My advice to readers is to use lesser-known and smaller investors if doing active investing.  If they have a a good record, use them.  You can benefit with them as they grow.

Sorted Weekly Tweets

Saturday, April 12th, 2014

US Policy & Politics 

  • Nearly Half of Dodd-Frank Rules Still Unwritten http://t.co/TwzSawT298 Experiment of regulation by study committees continues albeit slow $$ Apr 12, 2014
  • Banks Given Two Extra Years to Fully Comply With Volcker Rule http://t.co/XVfO9CKMm7 Banks prefer abolition; Fed offers a delay $$ #more? Apr 12, 2014
  • How Big Banks Created a Fed to Serve Their Own Interests http://t.co/tUlNYE3px5 Fed almost always ends up being a shill 4 the banks $$ $XLF Apr 12, 2014
  • Angry students snap photos of lunches, tell Michelle Obama: ‘You call this a [expletive] lunch?’ http://t.co/PY4gfa90oI Food Nazis r mean $$ Apr 12, 2014
  • On equal pay for women, Obama challenges GOP to ‘join us in this the 21st century’ http://t.co/wthQJKwsOO White House has own disparities $$ Apr 12, 2014
  • When the Messenger Is Worth Shooting http://t.co/GGuAxpkizc Fewer & fewer people think teaching financial literacy 2 avg ppl works $$ $SPY Apr 12, 2014
  • Republicans should be friendly to markets, not to business http://t.co/YXEWNr9MEh Big business excellent at co-opt laws 4 their own good $$ Apr 12, 2014
  • Maybe a Gender Pay Gap Is OK http://t.co/2rtYIZ6MFo This argumentation isn’t new; economists have been making this argument since the 70s $$ Apr 12, 2014
  • The Best SEC Money Can Buy http://t.co/wbwBB0CYd4 @ritholtz on Jim Kidney’s excellent retirement speech on the SEC which is worth reading $$ Apr 12, 2014
  • Food Price Shock, 2014 Edition http://t.co/u79xlrwK1I Note that the last time this happened, wars & other pains hit developing world $$ Apr 12, 2014

Market Impact

  • Hedge Fund Industry Growing With Pensions To Thank http://t.co/RF2FTh3YsD Probably a mistake as hedge funds tend not 2b good w/volatility $$ Apr 12, 2014
  • Hedge Funds Unwind As Growth To Value Rotation Intensifies http://t.co/XoK1RFKiAg As growth stocks correct, hedge funds chase performance $$ Apr 12, 2014
  • How Money Managers Fight Their Emotions and Sometimes Lose http://t.co/J0KH06m12P Too Bold? Not bold enough? Tough 2strike right balance $$ Apr 12, 2014
  • The Buys You Can’t Make Yourself http://t.co/0swRNG0Eyo @reformedbroker points out the value of @MebFaber ‘s global value ETF $GVAL $$ Apr 12, 2014
  • Humble Student of the Markets: A quant lesson from a technician http://t.co/svQilIRW4m Useful way to understand indicators & mkt regimes $$ Apr 12, 2014
  • 2014 crash will be worse than 1987′s: Marc Faber http://t.co/Guil41sSvP Bold w/respect to timing &severity of the next crisis, prob wrong $$ Apr 12, 2014
  • Do ‘rising rate’ ETFs really protect investors? http://t.co/tcx2p4qtuc I would b wary here; additional yield often carries hidden risks $$ Apr 12, 2014

Rest of the World

  • Kuroda Seen Brewing Yen-Weakening Surprise Action http://t.co/fVpFvwEiJz Don’t b shocked if the BOJ does yet more to weaken the yen $FXY $$ Apr 12, 2014
  • This is the bank to watch for a Chinese credit implosion http://t.co/sKL9NPruZz Minsheng is an aggressive lender 2the most dodgy credits $$ Apr 12, 2014
  • China’s steelmakers have branched out into shadow banking—which is funny since they owe $484B http://t.co/Z1IzHBJJ7G Brief stmt of prob $$ Apr 12, 2014
  • China Pizza Passion Has Fonterra Riding Mozzarella Wave http://t.co/J4605GnGK4 Pizza is so different than traditional Chinese food $$ $YUM Apr 12, 2014
  • Ukraine’s Rust Belt Faces Ruin as Putin Threatens Imports http://t.co/7BYk6ULy3t Russia has more ec influence on Ukraine thn US on Russia $$ Apr 12, 2014
  • Saudi Banks Reject Algosaibi Meeting on $5.9B Default http://t.co/6eZwowBlZW Islamic finance struggles w/debt that isn’t debt but is debt $$ Apr 12, 2014
  • Lavender-Filled Teddy Bears From Tasmania Are a Big Hit in China http://t.co/ubhWoUSnQz Bobbie Bear touches the hearts of Chinese ladies $$ Apr 12, 2014
  • Top economists warn Germany that EMU crisis as dangerous as ever http://t.co/gsqrbZ5ox0 Overall & banking leverage still higher than safe $$ Apr 12, 2014
  • Fracking’s hottest year in China http://t.co/5xVoKK6K0d China finds gas & tight oil in their shale formations. Who knew? $$ $FXI $XLE Apr 12, 2014

Companies & Industries

  • Time Inc. to Raise $1.4B in Debt for Spinoff http://t.co/8QUGvyKhrv I would b careful here; levering up old media not a recipe 4 success $$ Apr 12, 2014
  • Vox Takes Melding of Journalism and Technology to a New Level http://t.co/YdMuuu0ZQC Vox Media creates a content mgmt system 4 journalism $$ Apr 12, 2014
  • Trailer Parks Lure Wall Street Investors Looking for Double-Wide Returns http://t.co/zym4OmSDP5 Poor people have a hard time moving $$ Apr 12, 2014

Other

  • Stay-at-Home Moms Rise in Reversal of Modern Family Trend http://t.co/sCBErpTIhk Children deserve attention to help them grow up $$ $SPY Apr 12, 2014
  • More Moms Staying Home, Reversing Decadeslong Decline http://t.co/w7bnhw8tQd Value in efforts 2 produce better children w/more parenting $$ Apr 12, 2014
  • Font War: Inside the Design World’s $20M Divorce http://t.co/4YpYf1x5UN Not clearly spelling out a partnership agreement: font of trouble $$ Apr 12, 2014
  • Windows XP Goes Dark; Will Hackers Be Lurking? http://t.co/GPBJKpzdhf XP has been debugged; odds of significant holes are low $$ Apr 12, 2014
  • After Heartbleed Bug, A Race to Plug Internet Hole http://t.co/HCBfcHBl5O A significant part of internet affecting privacy had a hole $$ Apr 12, 2014
  • Global solar dominance in sight as science trumps fossil fuels http://t.co/BZOdAVwYbA Can capture 31% of sun’s energy with a 111V Solar Cell Apr 12, 2014
  • At Gross’s Pimco, El-Erian Says ‘Different Styles’ Stopped Working Well Together http://t.co/vRqPfRA67m Oil & water eventually separated $$ Apr 12, 2014

Wrong

  • Unsafe: Greece Plans to Issue Long-Term Bond on Wednesday http://t.co/X4gnld481q Lust 4 yield guides the behavior of debt investors $$ Apr 12, 2014
  • Misleading: Oklahoma Swamped by Surge in Earthquakes Near Fracking http://t.co/nHfPIWys3q All quakes r little which avoids big quakes $$ Apr 12, 2014
  • Wrong: Are Safer Cars Worth the Money? http://t.co/1N0Y9aklJb Misapplies benefit-cost analysis; may b cheaper ways 2 save more lives $$ $F Apr 12, 2014

Retweets, Replies & Comments

  • ‘ @foxjust Nice going; EEBS is breaktakingly honest with respect to earnings manipulation. cc: @jciesielski $$ Apr 12, 2014
  • RT @ReformedBroker: Reminder: The Fed’s own economic forecasts are basically worse than your dog’s. http://t.co/uLYirMA5zB Apr 09, 2014

On Rising Rate Funds, or, Who Remembers ARM Funds in the Early ’90s?

Saturday, April 12th, 2014

In the early 90s, there were not many investment actuaries.  One of the Holy Grail ideas of the early-to-mid ’90s was creating floating rate funds with yield so that floating rate Guaranteed Investment Contracts could be profitably written.  I chronicled my efforts there in this article.

One avenue that I went down and rejected was ARM [Adjustable Rate Mortgage] funds.  There was a minor craze for them in the early-to-mid ’90s, and there were not enough ARMs issued to meet the demand for high floating rates.  As such, the prices for blocks of ARMs rose above par, sometimes significantly.

One truism of buying mortgages at a premium in the ’90s was that the ability to refinance got sharper and sharper.  Those willing to buy mortgage securities above par usually took losses as rates fell.

Thus when I read articles about rising rate ETFs, which either invest short-term, or short the bond market synthetically or actually, I think “we’ve been here before.”  It is difficult to gain incremental yield on short duration instruments without taking on risks like:

  • Credit, including weak covenants
  • Structure (another form of credit & illiquidity)
  • Negative optionality

So be wary here.  Pay more attention to the return of your principal than the return on the principal.

I’m Not in This for Love

Friday, April 11th, 2014

Much as I appreciate those who like what I write at this blog, I don’t write to be loved.  I don’t write to be hated, either.  I am sensitive to what people think of me, but not to the degree that it changes what I write.

I may have nonconsensus views on:

  • The Federal Reserve
  • Gold
  • Social Security & Medicare (and their cousins around the globe)
  • The current Bull Market in Stocks and Corporate Bonds
  • Long Treasuries
  • and more…..

But I write what I write to disclose the truth.  I am an active equity manager, but I encourage people to use passive investing via index funds, unless they can find a manager who can reliably obtain outperformance.

I don’t blog for economic advantage.  If I wanted to do that, I could channel a wide variety of ideas on investing that are popular, but I know are marginal at best in terms of effectiveness.

Some friends of mine have told me, “Why don’t you write about companies that you own, or companies that look attractive to you?”

I’ve been burned by doing that.  For every ten that you get right, you get the same response from every one you get wrong.  As with most of the web, the complainers dominate.  That’s why I don’t trot out many individual stock ideas.  It’s not that I don’t have them, but I only share them as a group, not as a single idea, most of the time.

Summary

I’m here to tell the truth, even if it cuts against my own short-term economic interests.  Most of the time, I adjust my portfolio so that it is ready for everything, but sometimes I delay, because I know that changes in the market usually happen slowly.

I do not write to be popular.  I write to change the consensus, unlikely as that will be.  Finance is a perverse area of life where fear and greed take over.  And with academics, they have these lame models that are fit for Vulcans (maybe) but not humans (and certainly not Ferengi).

We need new models that reflect the fear-greed cycle, and make valuation a significant input in risk assessments.

I’m not in this for love; I only want to change the way that we view investment decisions.

To Live off of, and Die from, the Equity Premium and Alpha

Thursday, April 10th, 2014

I’m working on my taxes.  I’m not in a good mood.  Okay, writing that made me chuckle, because I am usually in a good mood.

Let me divide my working life into four segments:

  • 1986-1998: Actuary — reasonably well paid, and significantly underpaid compared to the value I delivered.
  • 1998-2007 — Investment risk manager, Mortgage bond manager, Corporate bond manager, and Senior Analyst at a long/short hedge fund.  Paid well for my efforts, and the  rewards to clients were far more than what I was paid.
  • 2007-2010 — Almost no pay, as I deal with home issues, provide research to a small minority broker-dealer, and try to gain institutional asset management clients.  Living off of assets from earlier days.
  • 2010-2014 — Living off of asset income as I slowly build a retail and small institutional client base for my value investing.

The last two periods are the most interesting in a way, because I was drawing more income from investments than I was from any other source.  Even during my time at the hedge fund, I made more money from my own investing every year than I was paid, and I was paid well.  That said the mid-2000s were a hot time, particularly if you made the right calls on a growing global economy.

My net worth today is roughly where it was at the peak of the markets in 2007, despite my low wage income.  I have been bailed out by the returns of the equity market and my alpha.

This is not a comfortable place to be, because general equity returns are not predictable, and alpha, though I have had it for years, is not predictable either.  That said, my client base has been growing, and in another year or so, my practice should support my family even if the markets don’t do well.

=-=-=-=-=-=–==-=-=–=-==-=–=-==–=-=-=-=-==-=–=-==-=-=-=-=-=-=-=-=-=-=-

Though I just told a story about me, the real story isn’t about me.  Think of all of the people who are trying to manage their lump sum in retirement.  They are relying on strong equity markets; they are hoping for alpha.  They are not ready for setbacks.

Unless you are seriously wealthy, when you are not receiving reliable income from a wage-like source, you can feel like you are in a weak position. I have felt that on occasion, but in general  I have not worried.

I write this because equity outperformance over bonds will likely be limited over the next ten years.  I peg equities at about a 5%/year average nominal return, with a diversified portfolio of bonds at around 2-3%/year.  Also the ability to add alpha is limited, because alpha is zero in total, and are you smart enough to find the managers that can do it?

In desperate times desperate men do desperate things.  Low interest rates are leading many to speculate more than they ordinarily would.  Equity allocations go higher.  Allocations to “alternatives” go higher.  People start using nonguaranteed income vehicles as if they had the structural protections of bonds.

As I always say, be careful.  Those trying to manage a lump sum for income in retirement are playing a dangerous game where if you try to draw more than 3.5%/year with regularity will prove challenging, because that is playing at the boundary of what the assets can deliver, and leaves little room for an adverse scenario.  Be careful.

Book Review: Letters to a Young Analyst

Tuesday, April 8th, 2014

letters cover (snipped)

 

We need to spend more time thinking about the big picture issues in investing.  Why do we do what we do?  How do we structure our firm to get the best out of the talented people that we employ?  Where do we really have a sustainable competitive advantage?

This slim volume has much advice in these areas, but focuses on how young analysts can make themselves valuable to the firms that they work for.

In addition to the advice of Tom Brakke, you get the advice of 12+ analysts, many of whom I respect, explaining the “nuts and bolts” of good analysis to young analysts.  I was on of the twelve, and judging from the other comments, there are many who remember what it was like to be young and grasping for help.  What would we have done differently, given our acquired knowledge?  This book is meant to give young and amateur investors a leg up.

The end of the book gives a wealth of resources on how the young analyst can learn.  In this era, it’s almost more of a question of excluding pervasive bad content.

This is a great book for young analysts, and serious amateur stockpickers.  If you are interested, you can buy it here.

Unlike most of my book reviews, there is no way for me to profit off of this one, not that I ever profit much off of my book reviews.  If you buy it, I encourage you to study it, because many older investors have given their best to aid young analysts.

Reaching For Yield

Sunday, April 6th, 2014

15 months ago I wrote a piece called Expensive High Yield – II.  High yield is still expensive.  I won’t post all of the regressions, but I have re-run them.  The results are largely the same as before.  Yields are low, and spreads are overly tight for everything except CCC bonds.

Much of this is the result of the Fed’s low fed funds rate and quantitative easing, which forces investors to take more risk.  Another aspect is the strong equity market.

Also, CCC bonds offering opportunity may not adjust for the loosening of covenant protections.  There is a tendency for investors to try to maintain yield levels while letting quality & covenants sag.  In a low interest environment, with more and more people retiring, there is a growing desire for the simplicity of yield.

My conclusion last time was this:

All of the corporate bond market is expensive relative to history, perhaps excluding CCC bonds.  That doesn’t mean it can’t get more expensive, particularly if stocks continue to move upward.   But this won’t last for more than two years; the signs of speculation are here, and that should make us cautious.

As a result, I am investing my bond strategy cautiously now.  What little yield I get comes from emerging market sovereigns.  Credit risk from corporates is small.

Well, I blew it with emerging markets; what a kick in the teeth.  I would have been better off in high yield.  As it is, for me and my bond clients, the strategy is Fire and Ice.  20% long Treasuries for deflation, 80% short credit instruments for inflation.  So far, so good.

Be wary in this environment.  So many are reaching for yield amid a weak economy with yields that are low relative to past trends.  But also be aware that a rising stock market can support the corporate bond market.  That has worked for the last two years, but it can’t work forever.

Best of the Aleph Blog, Part 24

Friday, April 4th, 2014

These articles appeared between November 2012 and January 2013:

On Time Horizons

Investment advice without a time horizon is not investment advice.

This Election Will Solve Nothing

So far that is true of the 2012 elections.

NOTA Bene

We need to add “None of the Above” as an electoral choice in all elections.

Eliminating the Rating Agencies, Part 2

Eliminating the Rating Agencies, Part 3

Where I propose a great idea, and then realize that I am wrong.

The Rules, Part XXXV

Stability only comes to markets in a self-reinforcing mode, from buy and hold (and sell and sit on cash) investors who act at the turning points.

The Rules, Part XXXVI

It almost never makes sense to play for the last 5% of something; it costs too much. Getting 90-95% is relatively easy; grasping for the last 5-10% usually results in losing some of the 90-95%.

Charlie Brown the Retail Investor

Where Lucy represents Wall Street, the football is returns, and Charlie Brown is the Retail Investor. Aaauuuggh!

On Hucksters

Why to be careful when promised results seem too good, and they get delayed, or worse.

Bombing Baby BDC Bonds

Avoid bonds with few protective covenants, unless the borrower is very strong.

On Math Education

Why current efforts to change Math Education will fail.  Pedagogy peaked in the ’50s, and has been declining since then.

On Human Fertility, Part 2

On the continuing decline in human fertility across the globe.

If you Want to be Well-off in Life

Simple advice on how to be better off.  Warning: it requires discipline.

Young People Should Favor Low Discount Rates

If we had assumed lower discount rates in the past, we wouldn’t have the problems we do now.  (And maybe DB pensions would have died sooner.)

Problems in Life Insurance

On why we should be concerned about life insurance accounting.

Investing In P&C Insurers

On why analyzing P&C insurers boils down to analyzing management teams.

Selling Options Cheaply (Did You Know?)

Naive bond investors often take on risks that they did not anticipate.

Book Review: The Snowball, Part One

Book Review: The Snowball, Part Two

Book Review: The Snowball, Part Three

Book Review: The Snowball, Part Four

Book Review: The Snowball, Epilogue

My review of the most comprehensive book on the life of Warren Buffett.

On Watchlists

How I met one of the Superinvestors of Graham-and -Doddsville, and how I generate investment ideas.

Why do Value Investors Like to Index?

How I admitted to not having  a correct perspective on value indexing.

Evaluating Regulated Financials

Why regulated financials are different from other stocks, and how to analyze them.

Locking in a Smaller Loss

Why people are willing to lock in a loss against inflation, because of bad monetary policy.

Why I Sold the Long End

Great timing.

The Evaluation of Common Stocks

Value investing is still powerful, but the competition is a lot tougher.

The Order of Battle in Financial Planning for Ordinary Folks

The basics of personal finance

Sorting Through the News

How to use my free news screener to cut through the news flow, and eliminate noise.

On Financial Blogging

So why do we spend the time at this?

Matching Assets and Liabilities Personally

How to manage investments to fit your own need for cash in the future.

Penny Wise, Pound Foolish

How short-sighted, incompetent managers destroy value.

Expensive High Yield – II

No such thing as a bad trade , only an early trade… high yield prices moved higher from here.

2012 Financial Report of the US Government

Chronicling the financial promises made by the Federal Government

On Insurance Investing, Part 1

On Insurance Investing, Part 2

On Insurance Investing, Part 3

The first three parts of my 7-part series on how to understand this complex group of sub-industries.

How to Become Super-Rich?

Even Buffett didn’t get super-rich by only investing his own money.  He had to invest the money of others as well.  The super-rich form corporations and grow them; they build institutions bigger than themselves.

The Product that Never saw the Light of Day

On the Variable Annuity product that would simply be a tax scam.  Later I would learn that product exists now, just not in the form I proposed 8 years earlier when it didn’t exist.

The Stock Market Is Rigged! The Stock Market Is Not Rigged!

Wednesday, April 2nd, 2014

After the announcement of Michael Lewis new book (which I don’t have a copy of, and I am not asking for one), together with a variety of interviews, he declared that the stock market is rigged.  This is a convenient finding that will gladden the hearts of many who have tried the markets and lost.  The trouble is, there are ways in which the market is rigged, and ways in which it is not.  There are ways to avoid much of the rigging, if are knowledgeable, disciplined and in control of your emotions.

Let’s start with a story.  My oldest son was an intern at a hedge fund that I worked at during a summer of high school.  He sat in with analysts, portfolio managers, and our trader.  He remarked to me, “The trading part seems like a lot of fun.”  I said to him, “Jason is a skilled trader, is good at discerning market conditions, and is able to trade our positions without divulging too much of what we want to do especially when stocks aren’t liquid.”

Another story: When I was a bond manager, and had to trade my portfolio (this is pre-TRACE where actual pricing data was scarce to anyone except the brokers who could see the inter-dealer market prices) realizing that the big brokers knew more than me, the regional brokers did not, and the little specialty brokers knew their niche at most, and nothing else.  I got very good at sniffing out potential trades, to the point where a number of my brokers would run ideas past me.  Most would not fly, a few would.

I learned that I had to be careful what I said and how I said it, because this was a voice-to-voice market, and not electronic.  Markets change when new information arrives.  I remember how delicate I had to be when I owned 35% of an illiquid bond that we liked, and I needed to sell it down without spooking the market.  I did it by telling the potential buyers that I really liked the bond, had no reason to sell it, but that I was a businessman, and would be willing to part with a few (million) bonds at a slightly higher price, more at a higher price, and a significant amount (20% of the issue) at a price that discounted most of the excess value of the bonds.  The bids came in, and I got the significant amount price, and  at a much higher price than had been previously seen for the bonds.

Now if I had done a “market order,” and said to a broker, “Sell half of the block at the current price,” I would have gotten a much lower price.  That would have signaled desperation.

Another thing from voice-to-voice trading, I would tell my brokers what I was doing with the proceeds of a sale.  I did not want them to think I had any special information that they did not have.  ”We need to raise cash to pay benefits.”  ”I see a class of bonds that are really cheap, and I need liquidity to do so.”  When I said those things, they were true, but it was like showing four cards of my poker hand, and hiding the fifth, the most critical card.

Information changes markets.  The reason that I mention bond trading, even though my target is stock trading, is that it was a *far* more rigged market because it was dealer-driven, and voice-to-voice.  It was far easier to lose to more skilled brokers, than trading stocks online today.

Now, Michael Lewis alleges that the market is rigged because there are clever high-frequency traders who trade quickly when they get significant information.  What information?  Market orders.  Market orders scream, “I gotta buy/sell the stock NOW!”  Motivated buyer, motivated seller?  That can change a market, if briefly.

Time for embarrassment.  I learned this one the hard way.  I was doing microcap value 1993-1998, with some significant success, but one day I slipped, and entered a market order for 1x the daily volume of a stock.  The stock’s price doubled before the order was fully filled, and then sank back down to very near where it was before I bought it.  To add insult to injury, the company was eventually a “take-under,” where control shareholders bought it out at a price even below that.

Don’t use market orders.  If people stopped using market orders, much of the advantage of high frequency trading would go away.  Use limit orders, and wait for your price, at the risk of the trade getting away from you in the short run.

Also, use orders that disguise your size and price you are willing to buy/sell at.  Reserve and discretionary orders are useful weapons to disguise your intent.  Also, get a low cost broker that charges commissions on a per share basis, and break up your trades into smaller chunks that are more easily digestible by the market.

But while trading is a large portion of the stock market reason to exist, it does not comprehend the true value of stocks.  There is a saying, and it is true: you don’t make money when you trade; you make money while you wait.

The stock market will not make any more value than the cash flows that get distributed by the businesses comprised there.  Some individuals may prosper from momentum trading, but it is at the expense of other investors, not the company.

The waiting game is not rigged.  As companies make money, and reinvest/distribute it wisely, value is built.  This is Ben Graham’s “weighing machine” versus the trading market’s “voting machine.”  In the short-run, trading dominates.  In the long-run, corporate value generation (or lack thereof) dominates.

Never Bring a Knife to a Gunfight

But there is away that the market is significantly rigged, but it is lodged in human nature, and not lodged in nefarious fellows who pick off little bits of value off market orders (a trifling amount of the value gained for longer-term investors).  Most of the people who believe the market is rigged are those who haven’t studied the market enough and thought it would be easy.  It’s not easy; and if you think that it is easy, you will be skinned.

Much money for less skilled investors gets lost as a result of buying near peaks (greed, or late imitation), and selling near bottoms (fear, or  capital preservation).  If you don’t have skill, far better to buy and hold, with a moderate asset allocation to stocks, thus moderating volatility, and moderating fear and greed in the process.

Have healthy respect for your competition.  Even the best investment organizations know that their edge in the market is limited.  Few pursue every possible advantage; the best understand this is a game where you win by applying your limited advantage where it is strongest, and stay neutral or out where there is no advantage.

Though professionals may be somewhat prone to many of the same pathologies as retail investors, and have the further disadvantage of putting a lot of money to work, still, the professionals apply basic principles day after day, and make the market the hard-to-get-an-advantage place that it is.

Rigged?

So is the market rigged?  It depends who you are.  If you understand your limitations, do your due diligence, and control your emotions, then no, the markets are not rigged.

If you naively presume that you can make money in the markets without adequate study, discipline, experience, etc., eventually the markets will seem rigged.

And if you are a short-term trader, the high frequency traders have eliminated a lot of the low hanging fruit.  The high frequency traders are a reason for even traders to lengthen their time horizons, and use trading tools that disguise their efforts.

For me, the markets are not rigged.  They are highly competitive.  I keep applying my edge, realizing that I don’t know it all, and focusing on investments where my differential knowledge may make a difference.

My summary is this: the markets are not rigged.  They not efficient; we don’t know what that means.  The markets are highly competitive, and that makes them tough.

PS — with thanks to my friend Josh Brown, whose clever piece made me decide to write this.  My conclusion is a little different, but at base I think we agree.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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