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Some Thoughts on Risk Parity

This is a very good piece by Cliff Asness on his new blog.  If you don’t follow it then add it.  Cliff is one of the smartest dudes around.  Anyhow, his firm AQR runs a strategy called “risk parity”.  I am not positive where this idea originated, but it was made relatively famous by Asness and Ray Dalio who has been running a form of risk parity for decades.  You can read Dalio’s description of the approach here.

I’m oversimplifying here, but the basic approach is to create a risk balanced approach.  So, if you have a 60/40 stock/bond portfolio most people don’t realize that over 80% of the portfolio’s performance is being driven by the 60% portion because stocks are so much more volatile than bonds.  So you’re not really in a 60/40 when you buy a 60/40.  You’re really in something more like a 80/20.  The idea of risk parity seeks to eliminate this imbalance by making the portfolio risk balanced.  This is generally done by overweighting the low volatility assets in the portfolio to make them equal contributors to the portfolio’s overall risk.  So, if you wanted to make a 60/40 more balanced you might buy a 40/60 stock/bond portfolio and leverage it up 1.5X. This gets you to the same standard deviation, but it beats the living daylights out of a 60/40 portfolio on a nominal and risk adjusted basis (over the last 20 years it generates a CAGR of ~11% vs the 8.4% CAGR of the 60/40 with better risk adjusted figures).

So, what’s good and bad about this approach?   First the good:

  • It’s a smart form of strategic diversification.  In other words, this isn’t just some cookie cutter index fund approach that anyone and everyone can implement.  It’s a very sophisticated and value adding methodology.

 

  • The focus on fixed income is a nice deviation from so much of Modern Portfolio Theory’s obsessive focus on equity returns and the nonsensical idea that “risk = returns”.  This changes the focus of the traditional debate by ensuring that shareholders are taking a more balanced approach rather than naively jumping into what they think is a “balanced index” like the Vanguard Balanced Index (which actually isn’t very “balanced” at all because the majority of the volatility is derived from the 60% equity portion of the portfolio).

 

  • Historically, risk parity portfolios add diversification to a portfolio in a way that reduces overall volatility and increases nominal and risk adjusted returns.

It’s not all good though (sorry Cliff).  There are some cons to the risk parity story (as there are in any portfolio):

  • The focus on “risk” as volatility leaves the door open for potential misalignment between the way client’s perceive risk and the way a portfolio’s risks are managed.  Shareholders don’t view risk merely as volatility.  This could result in periods of performance which don’t properly protect shareholders from the way they perceive risk.

 

  • There is some significant forecasting error risk involved in risk parity.  As with any allocation approach there is some degree of forecasting, but in a portfolio that is fixed income heavy the portfolio relies, to a large degree, on the positive risk adjusted returns of the fixed income portion.  This means that a risk parity portfolio, is, to some degree, a bullish forecast on the future of bonds (at least more so than a traditional balanced index).  The underlying model also involves some forecasting of changing risk dynamics.  This is difficult, if not impossible….

 

  • The portfolios are sophisticated.  The modeling is a little black boxy (is that a word?) because the idea of “risk” can be perceived differently at different points in the market cycle.  How risky are bonds in a world of ZIRP?  Who the eff knows?  Different models will come up with very different answers and so the degree of sophistication in the  black boxy model is a significant driver of future returns.  The investor doesn’t know how this is being done which creates some degree of added risk.

 

  • The fees on these portfolios are usually high.  We’re not talking about cookie cutter index funds here.  You’re paying for the modelling and strategic diversification that these portfolios add.  Personally, I am not always comfortable with a 1%+ fee structure, but given the degree of strategic diversification these funds add it could be appropriate for slices of a portfolio for certain people.

 

  • The leverage issue doesn’t scare me as much as it scares some other people, but it can be deadly in the wrong hands.  Leverage is like steroids – in the right hands it can be used in a controlled and intelligent manner.  In the wrong hands it can be very dangerous.  The use of leverage by someone like Asness or Dalio doesn’t scare me.  But you pay for that management expertise.

Now, the average indexer might say that risk parity portfolios are just another form of “active” management or a “better mousetrap”.  Well, I hate to inform you, but all of those Vanguard funds these indexers own are also active deviations from the global cap weighting being paraded as “passive” in order to create brand differentiation.  They’re just different forms of an actively picked index with lower fees.  They’re no less a “mousetrap” than any other index of assets that deviates from global cap weighting.  It’s just that people who buy Vanguard funds don’t often realize they’re in a mousetrap that’s just a lot less expensive than other mousetraps.

On the whole, I think risk parity is a smart approach, but like a lot of Wall Street’s recent innovations it’s probably too expensive to own in any substantial quantity.  That doesn’t mean it’s inappropriate for all asset allocators, but in a world where future returns are likely to be lower than most people expect the fee story becomes a glaring part of the equation.  If I could buy a risk parity portfolio for the same cost as a balanced Vanguard Index then it would be a no-brainer.  But we’re not there yet….

Read some more on Risk Parity approaches:

Why We Need Robots to Win the Technology War

Peter Thiel had a good piece in the FT today on the debate about robots and whether the rise of technology is a good thing or a bad thing.  I tend to fall on the side that says robots are a good thing, but I do acknowledge that the pace of technological acceleration is frightening precisely because humans can’t come up with enough alternative jobs to offset the rapid growth in robot-led job losses.  Still, Thiel makes an altnernatively superb point:

“Spiralling demand for resources of which our world contains a finite supply is the great long-term threat posed by globalisation. That is why we need new technology to relieve it.”

Technology is costing us jobs, but it’s also keeping costs down by reducing our dependence on the finite supply of natural resources.  We not only need the robots to win this war, but we are dependent on them to win this war.  Technology is the path to energy independence and resource independence.

As for the jobs, well, profit maximizing capitalists aren’t likely to solve that problem because they’re the ones leading the robot charge.  Which is great.  They’re not the bad guys in this war.  But we should realize that if they’re not going to fix the job problem then smarter government policy has to play a bigger role.  And that means lower taxes and more government investment.  Unfortunately, we’re still waiting for the capitalists to reach that magical and mythical “equilibrium” point for us.  And it just ain’t happening…

The Influential Indicator Pointing to Easier Fed Policy

Very good insight here from Sober Look – inflation expectations are falling fast again:

“The 5-year real rates in the US have recently turned positive, which some would suggest represents tighter monetary conditions. With real rates on the rise, the Fed will have a great deal of room to “slowroll” the rate hikes. If inflation expectations fall further, we may see a more dovish stance from the FOMC. “

Yes, that means one thing – if you’re betting on tighter Fed policy any time soon then this doesn’t bolster your case.  We’re seeing low inflation around the globe, continued economic weakness and with inflation expectations falling even further it means that global central banks have more breathing room to continue with their accommodative policy.

I continue to see lots of commentators talking about how “tapering is tightening” or how the Fed is likely to tighten in early 2015.  This indicator makes that a very unlikely scenario unless things change quickly and dramatically….

infl_exp

Boom/Bust Appearance: Macro Thoughts

I joined Erin Ade today on Boom/Bust to talk about some macro events.  The video can be found here, but here’s a brief rundown.  Oh, also, I’ll be joining a Boom/Bust roundtable discussion tomorrow to debate the merits of gold – Peter Schiff will be on the panel so that should be fun….

  • I briefly discussed why I wrote my book, Pragmatic Capitalism and how one of my main goals was to bridge the fields of finance and economics to hopefully provide a superior understanding of how both fields are much more closely intertwined than we often think.
  • Why endogenous money is so hard – in part, it’s because money is something that is a construct of the human mind.  That is, the whole financial system is not necessarily tangible or real in the sense that goods and services are.  So the idea that we have created this whole system out of thin air is not only difficult to comprehend because it’s complex, but it is also somewhat hard to believe in because, ultimately, that’s what our system is built on – trust.
  • Why the low inflation environment is a sign that future returns are likely to be much lower than many people expect.
  • Why buybacks are good for the near-term and bad for the long-term.
  • Why investors are going to have to come to grips with the likelihood of lower future returns.

 

“The Passive/Active Distinction is About Cost”

I really liked this interview with Joel Dickson of Vanguard.  In the interview he cuts to the chase on the active vs passive debate:

“The active/passive distinction is really more about costs than it is about the intelligence or the randomness of active management.  It is about costs”

I keep harping on this point because I think it’s very important to understand the asset allocation process.  The idea of “passive indexing” serves no purpose other than to create a distinction where there really is none.  That is, a buy and hold asset allocator who picks 500 large cap stocks to own is not doing anything all that different from the buy and hold asset allocator who buys the SPY S&P 500 ETF, IF HIS/HER COSTS ARE THE SAME.  But “passive indexers” would like you to believe that the stock picker is doing something distinctly different as if they are necessarily “active” just because they picked stocks.  This distinction is totally meaningless.  These two asset allocators are doing the exact same thing if they can construct their holdings in the same cost efficient manner (which, by the way, is precisely what firms like WealthFront are starting to do by owning the S&P 500 in its entirety).

So, this debate really comes down to costs.  John Bogle’s “Cost Matters Hypothesis” is the key lesson here.  But I think the “passive indexing” community got a bit overzealous in their demonization of “active” managers over the last few decades and didn’t fully realize that they were also picking assets inside the global aggregate.  Indeed, ALL INDEXERS ARE ASSET PICKERS who are just slicing up the global aggregate index in varying ways.  The difference between smart asset allocators and stupid ones is that the smart ones are fully aware of how much fees, frictions, behavior, etc hurt their long-term returns.  Still, none of this should trump the “Allocation Matters Most Hypothesis”.  That is, your active decision on how you allocate your portfolio over the course of your life will, by a wide margin, trump the “Cost Matters Hypothesis”.  So yes, we should be worried about costs, but not at the detriment of understanding the asset allocation process.

 

2 & 20 is Dead – 1 & 15 is on the Way Out….

The recent uproar over high fees is not a mere fad.  I think it’s here to stay and I think it’s going to get much worse for high fee financial firms who don’t adapt.  The problem is multi-faceted, but there are two huge headwinds coming for the high fee financial firms:

  1. Technological innovations
  2. A world of low returns

The first one is in our face every day.  You not only have enormous tech efficiencies in the way traditional advisors operate and the way markets operate, which reduces costs across the board, but you also have the robo-advisors and more automated services coming online which are driving costs down across the board.   This means that almost anyone can get reasonably good financial advice for 0.5% or lower.  And that figure could be on the high side as the years go by.

Further, we’re entering a world of low returns.  The share of outstanding public stocks has been reduced substantially relative to bonds over the last 30 years as interest rates have declined and it’s become more cost effective for firms to finance themselves via debt issuance.  And at the same time interest rates have been driven to zero by zero interest rate policy and weak economic conditions.  This combination means that the future returns on asset classes are likely to look nothing like they have in the past – particularly for the slice of asset holders who don’t own that reduced slice of the equity pie.  This means returns are likely to be lower which means that asset managers are going to be competing in an environment that is increasingly competitive for a reduced amount of return.  And as more and more investors realize that the high fee managers are cutting further into their returns than they did in the past they are likely to look for lower cost alternatives.

The uproar over 2 & 20 is just getting started.  Next we’ll hear about 1 & 15 and then 1 & 10 and eventually we’ll start hearing about hedge funds whose fee structures resemble traditional mutual funds (many of which are already on their death beds).  But the bottom line is, this isn’t the end of the decline in overall fees.  And that’s a great thing for investors.

Fed Rate Policy: Crafting a Game Plan

By Vadim Zlotnikov, AllianceBernstein

Capital markets could get a jolt if the US Federal Reserve raises interest rates faster and farther than expected. But we don’t think there would be a major sell-off in risk assets, and there are several ways for investors to play the possibilities.

Based on the pricing of futures contracts for the federal funds rate, the key US short-term policy rate, the market expects short-term rates to rise to 0.75% by the end of 2015. That’s almost half a percent below the target set by the Federal Open Market Committee (FOMC). In other words, the market doesn’t believe that the Fed will follow through on its announced rate-hike plans.

By itself, this disconnect isn’t too troubling. Historically, interest-rate increases from extremely low levels are generally positive for equities. So, even if the Fed raises rates sooner than markets expect, past data argue against a big decline in risk assets. And the business cycle would seem unlikely to turn down until inflation-adjusted interest rates rise higher than a range of 1.5% to 2%.

However, focusing on the timing and magnitude of the Fed’s policy actions may reveal short-term investment opportunities and help with long-term portfolio repositioning.

Take a cue from Fed guidance. If investors believe that the Fed will act in line with its statements, they can look to profit by taking short positions in fed funds futures, which are trading well below levels indicated by FOMC guidance. This type of position could benefit from faster-than-expected rate increases. However, it’s not easy to get the timing right—and being early could lead to losses.

Position for higher volatility. Investors can also position their portfolio assets to anticipate that markets will become more uncertain as the Fed starts to raise interest rates, which would lead to higher volatility and a general repricing of risk. One way would be a swap contract that pays off if volatility rises.

History suggests that there isn’t much impact on markets early in rate-hike cycles, but this time could be different. Corporate business models, financial products and investor sentiment are highly leveraged to the notion of persistently high market liquidity. Anything that might reduce that liquidity increases uncertainty. Entering this type of position is costly, so it’s important to have a view on the timing and size of rate increases to reduce the expense.

Consider “tail insurance.” There may be an opportunity to take a contrarian bet, because the cost of buying protection against a substantial upturn in inflation is very low. The price of an option that will pay off if inflation over the next decade is 2% higher than the current break-even rate—about 2% today—has collapsed. If an investor assumes that the Fed will be behind the curve and that inflation will accelerate, it could be profitable to buy some sort of insurance that goes against the grain of the widely held consensus belief of benign inflation.

Reposition toward rate-friendly investments. Investors might want to start rethinking their portfolio positioning. The goal is to reduce investments that are leveraged to persistently low interest rates in favor of investments with positive or neutral correlation to interest rates (Display). These investments could be equities of companies with large money-market funds, which could become profitable in a rising-rate environment, or a broader set of strategies with low or positive correlation to rates.

Zlotnikov_Rising-Rate-Environment_d1

Some investments, such as market-neutral strategies, are directly exposed to an increase in short-term rates. Others, such as real assets or inflation-protection strategies, take a more indirect route. They have a high beta—or responsiveness—to inflation expectations.

The sourcing for these investments should come from the most crowded strategies whose performance and liquidity are most leveraged to persistently low funding costs. In our assessment, these may include the riskiest tranches of high-yield debt; bank loans; infrastructure, farm and select real estate investments; and US equities with high debt/equity ratios.

Just because there’s a lack of certainty about how the Fed’s plans and market expectations will play out doesn’t mean investors have to sit back and wait.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Vadim Zlotnikov is Chief Market Strategist and Co-Head of Multi-Asset Solutions at AllianceBernstein

“Deactivated User Account”

This is the message you will receive if you tell the Bogleheads that their approach is misleading – you’ll get censored by their moderators.  I didn’t think I was doing anything all that insulting.  Yes, I was on their site saying that the idea of “passive indexing” is misleading.  But most of the Bogleheads (the one’s with no vested interest in the branding behind “passive indexing”) should have no problem calling themselves active asset pickers – it changes nothing for them.

Now, I was simply explaining how there is one portfolio of global financial assets in the aggregate (a simple fact) and how anyone who deviates from that market cap weighting is making an active asset picking decision (a simple fact).  I explained it this way:

A buy and hold stock picker picks thin slices of the aggregate pie by choosing specific securities within the aggregate of financial assets.  The “passive indexer” broadens his/her horizons and picks a fatter piece of the pie in a buy and hold approach.  Importantly, the “passive indexers” don’t advocate buying the whole pie which would be roughly a 40/60 stock/bond portfolio at present.  No, they advocate (for various active reasons like “factor tilting” or personal reasons) that you should deviate from cap weighting.

I was further explaining that the very foundation of “passive indexing” is grounded in general equilibrium theory and ideas like rational expectations – ideas that are virtually useless for practical application.  If I am right then this has important implications for portfolio management because it would mean that some degree of dynamism and asset picking in a portfolio is not just useful, but totally rational given that the financial system and the global asset portfolio is itself quite dynamic and actively evolving.

Now, some of this is quite difficult to understand because I am tying the economics directly to the finance, but the internal inconsistencies behind passive indexing really bother me.   If the world of financial assets is dynamic, quite actively changing on a daily (literally) basis and doesn’t resemble general equilibrium then how can a static portfolio approach like “passive indexing” be appropriate at all times?    It just can’t.  Some level of dynamism is rational in a portfolio even if it means reweighting on occasion to account for changes in the global market cap portfolio.  This obviously annoys some people because there is a lot of money to be made by pitching the idea that indexers are inherently different than stock pickers and diminishing the difference will diminish the value of the concept of “passive indexing”.

Anyhow, I’ve decided to write a formal paper about this topic because I think it is incredibly important.  The entire concept of “passive indexing” is somewhat misleading.  It draws a distinction between asset pickers and stock pickers when that distinction is far less meaningful than one might think.  This shouldn’t diminish from some of the useful concepts of indexing (like taking a long-term view, reducing costs, reducing taxes, etc), but when your entire portfolio process is constructed around misleading terminology and false precepts then it’s worth blowing up that foundation and trying to start over again.

I’ll be back with more on this in the coming months….

Warren Buffett is Right to Hate Gold

I really liked this piece by Matt DiLallo on why gold is so hated by Warren Buffett.  He provides the juicy details, but I’ll give you the quick and dirty rundown:

  • Gold is an unproductive asset.
  • Gold is valuable largely because people believe it’s valuable.

It’s not that Buffett is an ideologue or just on some anti gold rampage.  I think there are some logical and great lessons to be learned here:

  1. We build wealth by increasing our own production.  That is, we become more valuable to others within society when we do things that they find valuable.  This is why society rewards great innovators and people who tend to work hard.
  2. Betting on commodities like gold is often a bearish bet against human productivity and innovation.   When you buy a block of gold you are essentially buying an insurance asset whose value will increase if the value of dollars collapses or falls.  In other words, you are betting directly against the ability of US workers to produce and maintain the value of the dollar.
  3. Betting on gold is largely a bet on faith.  That is, you are betting on the idea that someone else will believe gold is more valuable in the future.  Although gold is valuable to some degree as a commodity there is also a substantial portion of the population who wants to own gold because it is viewed as money or protection against paper money.  I’ve referred to this in the past as a “faith put”, a premium in the price that inflates its value due to sheer faith.

I don’t mean to rant against gold.  I just think that there are some fundamental reasons to keep gold in the proper perspective when we consider its value as a portion of our asset holdings.  In my view, it’s not the type of asset you want to build a portfolio around due to the aforementioned thoughts….

On Getting Rid of the Monetary Triumvirate

I really liked this post by JP Koning who calls for us to get rid of the “monetary triumvirate”.  This is the idea that “money” has three elements as a medium of account, a medium of exchange and a store of value.  JP says we should dump the last two and just stick with the first one.  If you read closely you’ll notice that JP didn’t use the term “unit of account” as is more traditionally used when discussing this concept.  Instead, he’s referring to some specific thing as the medium of account.

Now, in order to be properly nerdy here we need to be more specific.  The unit account is just a measuring stick.  In the USA the unit of account is Dollars, in Europe it is Euros and in Japan it is Yen.  But the medium of account is an item that defines the unit of account.  During the gold standard the unit of account was dollars, but those dollars were measured in terms of a quantity of gold.  So gold was the medium of account.  But now that the gold standard is long gone the concept of a medium of account has become much more muddied because there is no single item with which we define the value of a dollar.  Deposits, reserves and physical dollars are all near perfect equivalents 99.99% of the time.  In my view, this makes the concept of a medium of account more confusing than it needs to be and potentially useless.

So I arrive at a rather different conclusion than JP.  If one is to understand the idea of “money” then the medium of exchange is a superior conceptualization.  And I think of money as existing on a scale of moneyness in which items with more moneyness are more suitable as a medium of exchange.  In today’s system bank deposits are the dominant medium of exchange because they are the item with which most transactions are settled at the point of sale.  Something like physical dollars or gold have a lower level of moneyness because they do not meet the definition of a medium of exchange to the same degree that something like bank deposits do.

But even though JP and I disagree on emphasis we agree on one thing – in a world of moneyness the concept of “money” actually has a lot less meaning than most people would think.  While it’s useful to understand how different financial assets are used in the monetary system for specific purposes it’s equally important to understand how those items are convertible into one another which gives them all varying degrees of moneyness.  And most importantly, we both agree that the monetary triumvirate muddies the waters of “money” unnecessarily.

Jack Bogle & Cliff Asness on the Markets

If you missed the Jack Bogle and Cliff Asness interview on Bloomberg TV just now then you missed a pretty great discussion.  Bogle and Asness are, arguably, the two most important people in the investment business today.  Bogle is the founder of Vanguard and the leading voice in the “passive indexing” movement.  Asness is the founder of AQR, a quant based asset management firm that runs more “active” strategies (asset allocation strategies) trying to generate better risk adjusted returns than the indices that Bogle says you should just hold.

Tom Keene was moderating the interview and did a fantastic job asking the right questions.  I only wish he’d asked Bogle what is “passive” about choosing an asset allocation.  As Asness noted correctly, anyone who deviates from the global cap weighted index, is making an active asset allocation choice, but neither Keen nor Asness directly noted that Bogle’s most famous investing style, “passive indexing” is largely a myth.  That is, no one can actually buy the global cap weighted index because the product just doesn’t exist.

Anyhow, here are some highlights from the discussion:

  • Both agree that future returns are going to be much lower than most people expect.  The 8-10% returns of the past are not going to come to fruition.  Bogle says 5-7% before fees would be a good return.
  • Bogle says bonds are going to disappoint in the future as the current coupons point to returns in the future that simply cannot match the returns of the past.
  • Asness argued that the financial sector has gotten too large.
  • Bogle emphasized that fees are still too high.
  • Both men agreed that ETFs are dangerous because they entice people to actively trade too much.

I basically agree with everything stated above.  I probably fall somewhere between the two of them in terms of my philosophy as I see us all as active investors, but I also think that most “active” managers still charge way too much for their services.  That places me very close to Bogle in terms of how important I place costs.  And while Bogle’s “Cost matters hypothesis” is clearly right, I emphasize the “allocation matters most hypothesis” which states that our active decisions to allocate assets are actually the most important driver in future returns.  By definition, this active allocation choice drives our returns and makes us all active investors to some degree….

 

Would a Repeat of the 1987 Crash Really Be That Bad?

By Ben Carlson, A Wealth of Common Sense

“The intelligent investor realizes that stocks become more risky, not less, as their prices rise, and less risky, not more, as their prices fall.” – Jason Zweig

If you’re in the business of fear-mongering, one of the go-to moves to try to scare investors is to predict that the markets are looking eerily similar to October of 1987.

Black Monday is forever seared into the psyche of every trader and investor that was part of the markets on that fateful day. Investors of today are constantly reminded about the time the S&P 500 dropped more than 20% in a single day.

1987

What many people don’t realize is that the three days leading up to Black Monday saw stocks fall over 10%, including a 5% drop on the preceding Friday. So in four days stocks were down more than 30%.

Interestingly enough, on a price basis the S&P finished the year basically flat, but on a total return basis, with dividends, was up around 5%. Doesn’t matter — crash, crash, crash is all anyone remembers.

It’s also worth noting that Black Monday didn’t even really derail the market. Here’s the S&P over a six year period from 1987 through 1992:

1987-1992

Now 1987 looks a little more manageable. Still a huge drop, but in the context of a market that was up over 120% or 14% a year from the start of 1987 through the end of 1992, not too bad. No one talks as much about the gains, but investors will always speak of the huge Black Monday crash. This is a classic case of short-term myopic loss aversionoverwhelming long-term market gains.

You could actually argue that the 1987 crash was a good thing for the markets. It knocked some of the wind out of its sails after more than doubling from 1982-1986.

From current levels, a 30% drop in the S&P 500 would take the index down to just over 1,400. That’s a mark last seen in December of 2012. So all of 2013 and 2014’s gains would be wiped out.

The S&P 500 currently trades at a P/E multiple of roughly 17x this year’s earnings. Earnings have actually grown more than 16% since late 2012 so a 30% drop would leave us with a P/E ratio of 12x. For anyone with a decent slug of human capital in the form of future savings, this type of swift wipeout would be a gift. Stocks would be marked down at a huge discount to current valuations.

This type of loss would tough for those with a mature portfolio, but for everyone else the biggest issue would be psychological. Stock market crashes are always thought of in terms of being frightening, scary and unnerving.

Earlier this year, Jason Zweig tweeted out that he once proposed the BGFN channel (Benjamin Graham Financial Network) that would cover market crashes as good news. Changing your mindset from how a crash affects your current performance to how it will affect your future performance is one of the keys to mastering your emotions when investing.

Historical market scenarios never happen exactly like they did in the past, so this is really just an exercise in crash preparation for the next time the market takes a dive.

These periods will never be easy, but they are necessary and one of the best things that can happen to an investor with a long time horizon, provided you have the right mindset.

Further Reading:
Even bull markets aren’t easy

Saving is not the Key to Financial Success

You’ve probably heard it a million times from financial “experts” – the key to financial success is saving.  The idea is that if we save more now then we’ll have more to spend later.  And while that’s true at the individual level it’s actually disastrous advice in the aggregate.   Saving isn’t the key to financial success.  Investing is the key to financial success.  A lot of this is counterintuitive, but stick with me for a few minutes.

Saving is our unspent income.  It is the residual of your income. And my spending is someone else’s income.  So if I decide to save more then someone else has less income.  All else equal, the economy has less spending power when I save more of my income.  If we all saved more then we’d all have less income.  So saving more can’t actually be the key to financial success because, in the aggregate, saving leads to lower incomes.  That’s simple enough, right?

Investment (not the financial type you’re probably aware of with regard to buying stocks and bonds) is spending, not consumed, for future production.  When you invest in your future you build an intangible (or tangible) asset that (likely) makes you more valuable.  In other words, when you invest in yourself you make your future production more valuable which makes your future income more valuable which allows you to save more of your future income in the future.   Importantly, investing adds to aggregate saving because one does not dissave in order to spend on investment.  That is, when you invest you have an asset that is as valuable or more valuable than your prior savings PLUS someone else has your spending as their income.

So, next time some financial expert tells you that the key to financial success is saving more tell them they have their economics precisely backwards.  The key to financial success isn’t saving, but investing in your own future production.

 

The Full Monty on Naked Short Selling

By JKH

JP Koning has written an interesting post that depicts banks as engaging in “naked short selling” when they simultaneously create new loan assets and new deposit liabilities. For example, he compares the idea of systemic deposit creation with the case of selling Microsoft stock without owning the stock (shorting the stock) and also without borrowing the stock (naked shorting the stock).

http://jpkoning.blogspot.ca/2014/09/getting-naked-in-praise-of-naked-short.html

“Just as an equity short seller will borrow and then sell Microsoft with the intention of repurchasing it at a better price, bankers borrow and then sell dollars with the intention of repurchasing them at a better price… In the previous paragraph you may have noticed that I described banking as the borrowing of depositors’ dollars in order to lend those dollars out. Because the dollars were borrowed prior to sale, this would qualify their activity as regular short selling, not naked short selling. But hold on, this isn’t at all how banks function. Bankers don’t wait for physical Federal Reserve dollars to be deposited by the public before selling them away… Banks are engaged in naked shorting pure and simple: they sell a financial instrument that they never actually had in their possession… How do they do this? The key here is that banks don’t actually sell Fed paper dollars short, rather, they sell dollar-linked IOUs (i.e. deposits) short.”

The post essentially says (I think) that banks engage in a sort of naked shorting exercise when they create deposits “ex nihilo” – that is without actually borrowing some form of funds in that process. Banks just issue new deposits to customers who take on new loans for example. Banks “acquire” a new loan asset without having “borrowed” “actual” “funds” to do so. So in a sense they have “sold” money (in exchange for a loan asset) without having borrowed it in the first place. Hence they are “naked short” in that sense. I think that’s the intended meaning, roughly.

An interesting question then is – naked short relative to what precisely?

Consider the counterfactual where bankers do wait for those dollars to be deposited before selling them away. According to the post, banks are naked short by comparison to such a counterfactual monetary system.

In this counterfactual system, it would seem there are at least two ways in which new deposits suddenly appear.

First, a bank customer can transfer or be the recipient of a transfer of money that already exists in deposit form in another bank. That transfer doesn’t change the level of system bank deposits. It happens through the bank reserve clearing system, and that is really no different than what happens today in the existing system.

Second, a customer can deposit central bank money in the form of banknotes. That DOES expand the level of system commercial bank deposits. And that is what would be different about this counterfactual monetary system. The level of system deposits in the counterfactual system – it would first appear – cannot expand in direct conjunction with new loan creation, but it can expand through new deposits of central bank money. This suggests a picture of central bank money circulating with a velocity that allows for banking system deposit expansion, assisted by a pace of central bank money expansion that boot straps that velocity. Conversely, in the monetary system that we actually have, customers who are granted new banking system deposits aren’t necessarily required to bring new funds into their bank to do so – in particular, a deposit customer doesn’t need to bring central bank money (banknotes) into a bank branch in order to receive a new deposit (i.e. a deposit that is both new to the bank and incremental to the level of already existing system bank deposits) – provided that customer can simultaneously borrow the funds from the bank.

But is this distinction between factual and counterfactual system actually meaningful?

The question at this point becomes how are new loans created in such a system? We know they don’t come into existence by simultaneous loan/deposit creation at a single bank.

One way a new loan can be made is by a commercial bank paying out central bank money (in the form of banknotes that it keeps in reserve) when it makes a loan.

What happens to that central bank money? What happens to those banknotes? Well, they are used in commerce until somebody deposits them back in a bank. And then they end up in that bank’s reserve account, along with other banknotes and reserve balances. Other things equal, the lending bank will have a reserve deficiency and the deposit taking bank will have a reserve excess. Those aberrations will be sorted out as necessary by each bank taking steps in the money markets in order to balance their reserve positions as desired.

But that is what typically happens in the existing system. The borrower will typically use the new funds in commerce and those funds will find their way to another bank. It is the same result. A new loan and a new deposit have appeared on the banking system balance sheet, and the result looks like the same type of “endogenous” money creation at the system level that already happens in the monetary system we actually have, once positions associated with the original loan and its associated deposit have been cleared. The counterfactual system simply skips the initial step in which a borrower has both a loan and a deposit with the same bank. But otherwise, endogenous money creation carries forward at a systemic level.

And what happens if the deposit that is created in this counterfactual system ends up landing back at the same bank that issued the new loan? Well, essentially that lending origination bank now has a new loan and a new deposit. The only difference from the case of the existing monetary system is that the loan and the deposit are issued to different customers now. But otherwise, the net balance sheet result is exactly the same, including the fact that the bank’s reserve account hasn’t changed on a net basis. A new loan and a new deposit have appeared on the banking system balance sheet, and in this case on the balance sheet of a single bank – similar to what happens in the existing system. So the net result looks like the same type of “endogenous” money creation that already happens in the monetary system we actually have at the level of a single bank.

Let’s take this one step further. For example, what is to prevent a borrowing customer in the counterfactual system from depositing central bank funds he receives from a new loan directly back as a deposit with the same bank he borrowed them from – even if temporarily? Is that going to be precluded as a counterfactual system constraint? This seems absurd.

So what purpose has been served by this counterfactual restriction whereby customers must deposit central bank money in order for system deposits to expand?

I see no constructive answer to that. This counterfactual system makes very little sense as a useful modification to the existing system.

A counterfactual system which precludes immediate loan/deposit expansion is really no different in effect from the existing system – even if you want to outlaw a borrowing customer depositing his own central bank money proceeds back with his commercial bank. Moreover, the idea that a bank with multiple, frequently transacting depositors needs to identify specific deposit monies before lending them out is a nonsensical impediment to standard bank liquidity management. Given the intra-day dynamics of money markets, the order of depositing and lending is largely irrelevant in this whole process of bank balance sheet management.

Conversely, the existing monetary system bypasses a questionable if not useless counterfactual constraint requiring all bank customers to operate with central bank money – by allowing the simultaneous creation of loans and deposits.

“Naked shorting” as a conceptual framework for banking only lives logically when “regular shorting” can be visualized by comparison. That context requires a counterfactual monetary system. And that counterfactual monetary system would seem to be a pointless tweaking of how the existing system operates. Indeed, “naked shorting” is fundamentally equivalent to “regular shorting” in the same context – as suggested above – just by visualizing a virtual flow of central bank money that connects the two key points of joint origination of balance sheet expansion – loans and deposits.

In summary, there is no problem in referring to bank assets as long positions and bank liabilities as short positions – in a relatively simple measurement paradigm of long and short gross balance sheet items from the perspective of the bank. (This is essentially the terminology of hedge funds.) An appropriate methodology (if desired) can then be chosen for netting such gross measures to a coherent summary of net “longness” or “shortness” for various types of exposures. At a high measurement level, a bank is net flat by virtue of a balanced balance sheet. But there are all sorts of ways of drilling down and becoming more granular in the description of effective net exposure. This is what hedge funds do in the case of third party positions in both assets and liabilities. Moreover, this is also the essence of bank asset-liability management across all types of risk – including liquidity risk, structural interest rate risk, structural foreign exchange risk, and all types of trading book market risks. It’s a matter of specifying what the measurement methodology is for gross and net exposures. But it seems to me that given the inevitable reality of endogenous money creation and the sensible clearing short cuts inherent in that process, the underlying “non-naked short” idea from which the idea of “naked short” must be derived is itself quite dubious, making the associated concept of “naked short” a somewhat questionable although very interesting characterization of bank deposit creation.

Three Things I Think I Think

Some weekend thoughts….

1)  Vanguard now manages $3 trillion in assets which is the same as the entirety of the hedge fund industry (see here for more).  This is fantastic news.  It means that low fees are winning.  When one considers that the S&P 500 generates just a 6.5% real, real return historically you have to be increasingly mindful of how much of that result is due to your fee structure.  When you’re paying 10, 20, 30% of your returns per year to a manager then you’re probably paying too much.  This is likely to be even more important going forward as bonds are likely to generate lower returns than we’re all used to so this means that high fees will cut into your returns even more than they used to.

It’s a wonderful time to be an asset allocator.  Products have never been more accessible at such a low cost.  You just have to make sure you’re being smart about your approach.  Know that even when you use low fee index funds you’re making an implicit forecast.  Know that you’re making active allocation choices.  Know that if you pay someone to do this on your behalf then you’re essentially paying for their ability to manage that allocation process for you.  The necessity of actively managing ones portfolio isn’t going away just because the fees are coming down.  So go into all of this with your eyes wide open and don’t assume that low fees necessarily lead to a better process.

2)  Back in 2011 I made one of my rare bubble calls on silver (see here).  Well, silver has just about round tripped its price gains on a 5 year basis now:

silver

 

I think this is one more lesson in understanding the importance of the capital structure and the monetary system.  The silver bull market was never based on sustainable trends.  It was based more on speculation about the effects of QE and the many high inflation predictions we heard in the last decade.  But at the end of the day commodities are primarily cost inputs in the capital structure and they’re very unlikely to generate sustained returns that are well above the rate of inflation.

3)  Speaking of silver – I think this is a good time to revisit the post I wrote almost a year ago on “The Biggest Scam in the History of Mankind”.  This was a really well done video selling gold and silver as protection against the “scam” that is the Federal Reserve and the US government’s “printing” of money.  I said this video was incredibly misleading and that the people who made it were likely just trying to sell you silver and fear in exchange for your hard earned dollars.

I can’t stress how important this is because I really honestly think that a superior understanding of the financial system can help you avoid so many of these hucksters.  And anyone who understood the financial system and the monetary system would watch a video like this one and simply laugh.  So please, if you didn’t read that post try go read it with an open mind.  And if you have questions then please use the forum or the comments here.