Month: September 2014

What about commodities?

I’ve been posting a lot about seeking diversification….so what about commodities?  I mean, surely they’re the obvious addition to an equity/bond portfolio?

Hmm… kinda.  My 2 cents on commodities:

  1. Long = wrong.  Long-only commodities is a poor choice, in my opinion.  I think of it this way: there is no fundamental reason for commodities to endlessly grow – unlike, say, equities.  Yes, each area of commodities (grains, metals, energies) has had a good run at different times.  But they can fall seemingly without end (such as grains recently).  A vehicle for those who disagree with me can go for an ETF such as DBC to keep long commodities exposure.
  2. Roll yield matters.  Another reason I don’t buy long-only commodities is the roll cost.  Back in the day (I’m thinking JM Keynes’s “normal backwardation” concept) most commodities paid long positions roll yield; incidentally this became a large part of the return for holding commodities.  With the advent of much long-only money, backwardation became contango; thus long-only has to pay for the privilege of holding a position.  I don’t like this.
  3. Simple strategies help a lot.  Back to my days in hedge fund land.  Just about any combination of momentum, carry, and seasonality strategies can outperform long-only.  So I stick with these.

In sum, these reasons underpin one of the key reasons I picked a managed futures mutual fund the other day.  Access to that different return stream, without paying away the roll yield each and every month.

Finance 101: Part 4, extension – Derivatives

Last post completed a listing of various savings vehicles.  In sum, one can purchase a variety of securities (e.g. stocks, bonds) and/or strategy funds.

Let’s complete the picture with probably the most complex, and potentially risky, component of an investment portfolio: derivatives.  These instruments can be used for a variety of purposes, as part of an overall portfolio.  Unfortunately, they require close scrutiny; their inbuilt leverage means you need to monitor your portfolio at least daily.  That probably excludes most savers.

In any case, here we go:

  1. Options (puts/calls): these are contracts between buyers and sellers, with reference to some underlying asset (usually shares of stock/indices, or futures contracts).  The option contract gives the buyer the opportunity, but not the obligation, to buy the underlying (in the case of a call) or sell the underlying (put) from the option seller.  So if I buy a call option on AAPL stock, I pay someone for the opportunity (but not the obligation) to purchase AAPL at a pre-decided price.  For the opportunity to do that, I pay the call seller a small premium.
  2. Futures: these are contracts between buyers and sellers, with reference to some underlying asset (e.g. shares of stock/indices, certain amounts of commodities, bonds).  The futures contract gives the buyer the obligation to buy the underlying at a future date, at a pre-decided price.  So if I buy a futures contract on soybeans, I have agreed to buy a set amount of physical soybeans, for a set price, at a specified date in the future.  I don’t have to pay a premium for the futures contract – I just post some surety margin with the exchange, to honour my obligation.
  • Benefits of derivatives:
    • Leverage: instead of using borrowed money to buy securities, one can use futures and options.  Both have inbuilt-leverage: after all, both are just contracts between buyers and sellers, and both parties want the leverage.
    • Flexibility: particularly in the case of options, the user can specify maximum loss vs maximum gain and/or probability of success.  Instead of basing gains/losses on underlying gaining in price, these derivatives allow shorting and neutral positions (e.g. positions which make money when the underlying doesn’t move).
  • Drawbacks of derivatives:
    • Leverage: having the ability to make levered bets is a blessing and a curse.  At its worst, poor money management can wipe out an entire portfolio – even with a relatively small move.
    • Complexity: particularly in the case of options, these are influenced by several factors other than underlying price moves.  Unless the user understands all the contributors to option value, profit/loss will come for unknown reasons!

Reasons I use derivatives in my portfolio:

  • Defining maximum loss: I like the feeling of knowing exactly how much I’m going to lose in a worst-case scenario.  For example, with the stock market vacillated around all-time highs, I’ve replaced my underlying securities with options; now my maximum loss is the premium I’ve paid for the position.
  • Inexpensive leverage: margin debt is expensive, and I don’t like the idea of needing to liquidate holdings when the market falls (see 2008).  I can achieve the same, or better, leverage with options at a lower cost and no need to worry of forced liquidation.
  • Getting paid for time: option values are partially determined by time to expiration – therefore the option seller receives payment (through the amortisation of option premium) for passing time.  Combining this point with the above 2 points, I can get paid for time passing.

In summary: derivatives give a lot more flexibility to an investment portfolio, but requires a lot more TLC.  Most savers won’t ever touch these, but for folks with an interest in derivatives I can recommend the guys over at tastytrade for information resources.

Finance 101: Part 4…part 2: Overview of savings vehicles, alternatives-style

The previous post focused on ‘conventional’ savings instruments – bank accounts, bonds, stocks, real estate.  Most of what I’ve read on other blogs/books/websites stays on these topics.  In fact, even the CFA curriculum stays pretty safe on these topics: Alternative Investments are kept at mostly a conceptual level.  That probably makes sense, as most people won’t go for alternatives; they’re kinda ‘new’ relative to stocks and bonds.

As I wrote in a previous post, I’m always looking for more portfolio diversification: investments which perform at different times (and/or in different ways) than conventional stocks and bonds.  Here is my list of alternative investment vehicles, ranked by my view of increasing risk/complexity:

  1. Most hedge fund strategies:  in days of yore, hedge funds used to be high-octane, high-risk performance vehicles.  As the investor base for hedge funds has shifted towards risk-averse institutions, most hedge funds have lowered their risk; often risk is lower than equities.  This bucket includes Long/short equity, merger arbitrage, event-driven, convertible arbitrage, fund of funds… most strategies.  Most individuals can’t access the ‘flagship fund’ (i.e. the fund charging full 2 and 20 fees), unless they’ve a financial advisor who usually charges additional fees on top.  More affordable alternatives include alternative beta mutual funds (e.g. AQR) or ETFs (e.g. GURU).  These funds tend to provide the least diversification to conventional equities, so up to you whether you include.
  2. Macro/managed futures/CTAs: both discretionary and systematic macro or managed futures strategies fit here.  For the icons, think George Soros or Paul Tudor Jones: big calls on macroeconomic themes.  From a statistics perspective, these funds are based around momentum trading: buying when prices rise, and selling when prices fall.  For a conventional long equity/bond portfolio, the best bang-for-the-buck diversification comes from this strategy; they were the only guys making money during 2008.  Same with #1, flagship funds typically charge 2 and 20 or more; affordable options are managed futures mutual funds (see earlier post on fees) or ETFs.
  3. Master Limited Partnerships (MLPs): the US has a tax-efficient structure (similar to a REIT, covered in last post) for infrastructure investments.  Think natural gas pipelines, cell phone towers, etc.  These are traded on exchange, so pretty liquid.  Dividend yields can be pretty attractive as well, provided they’re sustainable.  MLPs had a very tough 2008-2009, so diversification against equity is good in the good times, but bad in the bad times.
  4. Private equity funds: in particular, I mean buyout funds.  The idea is pretty simple: buy a company with a ‘mortgage’ – e.g. borrow a large portion of the purchase price from lenders.  The interest cost is tax-deductible for the target company, so the tax savings alone sometimes makes this a worthwhile investment thesis.  Buyout funds are similar to hedge funds in lack of liquidity (flagship buyout funds frequently lock up capital for 3-5 years) and high fees (buyout funds typically charge 2 and 20, as well).  Affordable alternatives, to me, are buying the shares of listed buyout firms like Blackstone or Apollo.
  5. Venture capital funds: let’s find the next Facebook, shall we?  The business plan for these funds is like a baseball player who always swings for the fences: some investments return zero; some break even; and a small proportion return so much, they pay for all the failures and then some.  Similar terms to buyout funds, and diversification benefits versus public equities is up for debate.  Big firms like Blackstone have venture funds; otherwise you may be out of luck getting into these ‘sophisticated’ investment funds.
  6. Volatility arbitrage: getting into the more exotic realm here.  The idea is that implied volatility (of options) is almost always overpriced relative to actual volatility (of underlying assets).  This is a prime example of ‘it works until it doesn’t’: many of these funds lost 50-75% of capital when markets crashed in 2008.  Those that survived have made most of it back, I think.  How do you feel about keeping invested in a fund that’s lost 75% of your initial investment?  Anyway, most funds are small, expensive, and near-impossible to access.

What did I miss?  Derivatives! It’s a bit outside a 101 course.  I’ll cover basics next time.

Latest addition to the portfolio: managed futures mutual fund

An earlier post outlined my thoughts on the stock market at these levels… given the volatility of the past few days, I’m even less certain of near-term performance.

Anyway, I continually seek out diversification in my portfolio: strategies or asset classes which perform at different times than my core long-equity allocation.  These days I’m less certain about asset-class diversification; with ultra-low interest rates, long fixed income seems a bad bet.  Commodity prices have been crashing, so maybe long commodities is an option.  Real estate prices have had a good run, but I’m unconvinced they can hold their own when rates rise.  Option volatility has ticked up lately, but still at very low levels.

So what next?  Strategy diversification.  For example, if I’m reasonably sure that long fixed income is a bad idea, how about going short fixed income?  If I’m unsure about when commodity prices will turn around, how about using a momentum strategy?  These type of strategies are employed by managed futures funds.  The upshot is the funds’ ability to diversify my long-equity portfolio: due to the strategies employed, momentum-focused managed futures funds have around zero correlation to equities.  That’s about as good as diversification gets.  In addition, the momentum strategies used means an opportunity to short stocks when they’re falling (e.g. in 2008, when the funds made good money while other strategies were killed) – so a bit of an offset for my long equities during a selloff.

One of the main reasons to hate managed futures funds of late was fee loads: most of these strategies charged hedge fund fees (2 and 20, or more).  With the new crop of mutual funds, however, the strategies have much more palatable fee loads (more like 1% p.a.).  Much easier fee hurdle to beat.  So just be careful when choosing a fund – the performance of momentum managed futures funds should be highly correlated with each other, so stick with lower cost options.  This often means looking in the prospectus (!) or even SAI (!!) to find out what ‘hidden fees’ are paid to the hedge fund manager.  Hint: if you see a clause like the following, below the breakdown of expenses, think ‘hidden fees’:

The cost of swap(s) and structured note(s) include only the costs embedded in the swap(s) and note(s) that reduce returns of the associated reference assets (i.e., Underlying Pools), but do not include the operating expenses of those reference assets. Returns of swap(s) and note(s) will be reduced, and their losses increased, by the operating expenses of the Underlying Pools used as reference assets, and such operating expenses may include management and performance fees of a Commodity Trading Advisor (“CTA”) engaged by Underlying Pools, as well as Underlying Pool operation, administration and audit expenses One or more of the Underlying Pools used as a reference asset for a swap(s) or note(s) may pay a performance fee to a CTA, even if the return of other reference assets associated with the swap(s)/note(s) is negative. The operating expenses of reference assets, which are not reflected in the Annual Fund Operating Expenses table above, are embedded in the returns of the associated swap(s)/note(s) and represent an indirect cost of investing in the Fund. Generally, the management fees and performance fees of a CTA employed by the Underlying Pools that may be used as reference assets range from 0% to 2% of assigned trading level and 15% to 25% of the returns, respectively. 

I stay away from these funds.  There are managers/funds out there worth the fee loads, but I’m too small an investor to access them!

Finance 101: Part 4 – Overview of savings vehicles

There are seemingly infinite options available for savings these days.  I probably understand more than many, but definitely only a subset of the cornucopia one can put money to work.

For those looking for an intermediate text on investment vehicles and strategies, I can definitely recommend Expected Returns by Antii Ilmanen.  I’m sticking with the basics here.

Savings vehicles, listed in order of (my perception of) complexity and risk:

  1. Government-insured bank deposits.  No real description needed.  If kept below the insurance level, these balances have a place for instant access and emergency funds.  I recommend Money Saving Expert or Bankrate.com for comparing best rates.  Remember – if the bank is government insured (I’m clenching a bit due to the IceSave situation, but we can talk about that another time), the only factor that really matters is the interest you receive.  It’s all the same otherwise!
  2. Bank Certificates of Deposit (CDs).  Same as #1, but this time you’re locking up your funds for a certain period of time.  If you need the cash earlier, you’re paying away some accrued interest or even principal.  Some CDs aren’t government-insured, so be aware.  Use the same resources as #1 for the rate comparison.  Choose a time frame which you’re happy to lock away your money.
  3. Government bills.  Treasuries for Americans; Gilts for Brits.  They’re as safe as #1 and #2, but less accessible.  Use TreasuryDirect to buy Treasuries from the government (to avoid brokerage charges).  The DMO in the UK has info on buying Gilts; not as easy as Treasuries!
  4. Money market funds.  Most probably experience this as the ‘cash sweep’ option on their brokerage accounts.  These are not insured, but invest in high-rated, short-term government and corporate debt.  Biggest additional risk here is credit risk, but generally minimal.  Another problem these days: yield on these funds may be the same or lower than management fees, so you won’t make any interest!
  5. Government bonds.  The difference between #3 and this is duration – similar to the difference between #1 and #2.  If you purchase a 10-year Treasury, you’ll need to hold for 10 years to get the full yield; selling on the secondary market means you may lose more than your initial investment.  With interest rates at near-record lows everywhere in the world, I think long-dated bonds are as risky as they’ve ever been.
  6. Investment-grade corporate debt.  This takes #5 and adds credit risk.  According to the book referenced above, there is little to be gained purchasing investment-grade debt rather than government debt in the long term.  Beware, those who chase the extra yield of corporate debt; frequently they’re priced correctly.  Utilise brokerage accounts to purchase these; there is no exchange, so you’ll have to buy directly from a dealer.  Which reminds me of the stories of BMW-driving, mansion-owning bond dealers.
  7. Utility stocks.  I put this as in-between debt and equity, for personal investing.  Steady cash flows and high regulation mean these guys have high financial leverage, but can sustain that and recurring dividend payments that frequently exceed corporate debt interest.  Keep in mind that, as interest rates move higher, these utilities will use more of their cash flows to pay debt interest rather than dividends.
  8. Broad stock indices.  In particular, S&P 500, the Nasdaq, FTSE 100, MSCI World, etc.  This is generally what is meant by pundits when they say ‘buying the market’ or ‘stocks moved higher/lower’.  Purchase low-cost index tracker funds (see Vanguard, for a start) or Exchange Traded Funds (ETFs), with the smallest possible fees, across a range of geographies.  For the majority of savers/investors (I’d wager), this category represents the vast majority of their portfolios.  Or should.
  9. Real estate Investment Trusts (REITs).  These are equities, purchased through your broker, which mirror the returns of holding/building/financing real estate.  They generally pay out healthy dividends, but their capital is very much at risk both to interest rates rising and to an economic downturn.  On the plus side, they tend to diversify a little bit from the overall equity market.  I’d recommend purchasing an ETF basket of several REITs, rather than any single name.
  10. Individual corporate equity.  Think you’re good at picking stocks?  It’s extremely unlikely you’ll beat the indices in #8.  A big issue is skewness of returns: purchasing equity in a single company means you have a much higher risk of losing big (that company might declare bankruptcy, after all).  This issue isn’t really an issue with #8.  The same goes for actively-managed stock mutual funds: time after time, these funds underperform #8.
  11. High-yield corporate debt.  Why more risky/complex than equities, you ask?  How much do you know about recovery rates, and their correlation with the business cycle?  Can you understand senior/subordinated loans and bonds, either with or without security?  The book mentioned above finds no benefit of owning high yield credit above Treasuries, with the exception of ‘fallen angels’ – companies who become high-yield from previously investment-grade.  Anyway, credit spreads are near all-time lows, so methinks this is a tough area to enter.
  12. Real estate.  Yes, this includes purchasing your first house.  Folks in London can’t stop talking about real estate prices, and ‘getting on the housing ladder’.  Here’s why I put this type of investment so low on the list:
    1. Lack of diversification:  putting aside calamities which may or may not be insurable: what if your neighbourhood goes to the dogs?  Your house may not be worth anything like what you’ve paid for it.
    2. Leverage, leverage, leverage:  few folks buy their first house in cash; mortgages are essential.  If you have 5% as a down payment, you now have 2000% leverage on a (non-diversified) investment.  Fantastic news if house prices march ever-upwards; horrible news if you purchased in 2007-2008.  See this fun/depressing map from Zillow to see how many people are still underwater on their houses.
    3. Ancillary costs: who knew prepping a house for sale could be so expensive?  Or the realtor fees?  The market is generally illiquid, so hopefully one can get a reasonable price for the house when it’s selling time.  As for buy to let: management fees and capital expenditure can be unknown and expensive.

OK, off my soapbox on the last one.  I will continue the discussion, into alternatives, in the next post.

Latest strategy I’m trying: monetising vol-drag

I wrote before about why I love UVXY and other leveraged ETFs.  In a nutshell, they’re completely designed for day-trading; if you hold one longer than a day, you’ll likely be disappointed with the performance.

Away from the pretty straightforward UVXY trade I mentioned, I’m now trying a similar strategy with IWM & TZA.  Thesis is similar:

  • TZA is -3x the daily % return of IWM.  So if IWM goes up 1% in a day, TZA falls 3%.
  • Unlike volatility, I find no reason to believe IWM should mean-revert.  So I need to hedge the underlying exposure of TZA with IWM.
  • Over time, TZA has similar issues as UVXY: volatility drag due to Jensen’s inequality, as well as negative roll yield (being short IWM futures, which have pretty stable backwardation).
  • I am hedging just to start the trade – over time, the hedge will be less effective; however, I use long put options, which means gamma should work in my favour.
  • Overall, this looks to replicate a long variance-swap position on IWM.  I should be getting credit (i.e. decay) for IWM moving around prior to option expiration.  If IWM doesn’t move around enough to cause the decay in TZA, I’m out the option extrinsic value for both sides (ouch).

I’m interested to see how this moves over time.  Hopefully not walking into a quagmire.  Anyone have experience with this trade?  Let me know your lessons!

Finance 101: Part 3 – Getting started with saving/investing

Continuing forward on our exploration of personal finance.

Suppose we’ve decided to save for something – see the previous post for some ideas of how much one should be saving for various life events.  How should one put that money to work?

The investing world is full of instruments/strategies/accounts/advice for how to save money.  It’s a mess, frankly.  I think this is because the financial world is as about as important to our individual lives as medicine, but not regulated anywhere near as tightly:

  • My impression is most people understand little about finance; the same goes for general health.  We’re led by rules of thumb like ‘cover your head when your feet are cold’, ‘drink 2 litres of water per day’, or ‘put your age, as a percent, of your investment portfolio in bonds versus stocks’.  These are generally gross oversimplifications, nudging us to good behaviour.
  • When we really don’t know what’s going on with our health (if we have a big problem), we go to a professional.  We know our health provider is a professional, because he/she’s been certified as such by one of various government-regulated organisations.  He/she has likely passed strenuous exams, had long internships with other doctors, etc.
  • Naturally, we’d like to do the same when we’re in the same financial health.  Unfortunately, there is 1 big reason why finding a financial professional is much more difficult than a health professional: no consistent certification. 
    • Anyone can dispense financial advice.  I guess that’s partly what I’m doing here.
    • When I took the US Series 7 and 63 exams – allowing me to manage others’ portfolios and/or sell securities to individuals – I was stunned how basic the knowledge requirement was for passing the exams.
    • The Chartered Financial Analyst (CFA) exams were a better challenge.  At least people who pass these exams needed to have a decent understanding of investment process, the universe of investments, and basic valuation at exam time.
    • Bottom line: ‘believe nothing that you hear, and half of what you see’ comes to mind.  Searching out a helpful financial advisor is really tough when there’s no real regulatory separation between hacks and strong performers.

What to do, then?

  1. Basic education.  Like reading this blog, or writings from some of the links at right.  There will be a lot of differences of opinion, but the basic facts should be the same.  What are your options and opportunities out there; what are reasonable expectations (e.g. don’t expect 20% return on stocks each year, and don’t expect 0% interest rates on savings forever, either).
  2. Get talking.  As someone who loves talking about money, I always have to remember (or get reminded) that ‘money isn’t something we talk about’.  I say: enough of that.  Ask friends and family what they’re doing about saving (e.g. ‘have you found a good rate on bank savings?’, ‘do you use a financial advisor?’).  Exception: don’t ask around for stock tips or the like, as a) it likely will make others uncomfortable, and b) I believe few really tell the truth of all their winners AND losers.  It’s like a Facebook profile: only the good stuff comes out.
  3. Make an informed decision whether to use a financial advisor.  There are loads of decent resources online, as well as tons of free tools from discount brokers these days.  If you have the time and temperament to manage your savings, I recommend it.  It’s like having the time and desire to build your own car – you will have a better idea what can go wrong, and how to fix problems as they arise.  If you don’t have the time and temperament, shop around (including using personal referrals) for a financial advisor.  In my opinion, don’t expect an advisor to outpace the markets consistently; just expect them to have a strategy, and stick with it.
  4. If you’re managing your own money, get reading!  I believe more reading is better, as long as it’s more educational than news-driven.  For example, I’m a big fan of finance textbooks (see some of my previous posts), but not such a fan of the latest and greatest ideas coming from CNBC or Marketwatch.

More concrete definitions/explanations of savings vehicles next time…  stay tuned.

On multi-class shareholder structures

The successful IPO of Alibaba (for the company/insiders/initial holders of shares/underwriting banks) reminded me of an enigma in today’s stock market: multi-class shareholder structures, and what that means for shareholder rights.

In a Finance 101 world, a company issues some number of shares to be purchased by outsiders in an IPO.  Each share represents an equal right to the decision making of the company (i.e. 1 share = 1 vote), as well as an equal right to the residual profits of the firm.  So far, so good.  Perhaps few buy the shares thinking of using the voting rights (I think most people don’t vote their shares, and I think it’s mainly just the activist hedge funds out there that force change through buying shares), but the knowledge that it’s there should be of some comfort: if management really stinks, the shareholder can express an opinion which may enact change.

Enter these multi-class structures, whereby insiders/founders keep most the voting rights, then offer the public shares in either some or all of the economic gains of the company.  The Economist has a good article on this recently: the structure isn’t new, nor is it allowed in many stock exchanges around the world.  US exchanges seem to be about the most OK with it – hence a reason for Alibaba’s IPO on the NYSE last week.  These structures also exist with other big tech names, such as Google.

I guess my issue with these structures is that most of the public will never read the T’s & C’s of their IPO offering documents when placing orders for new shares.  They won’t know/care that they’re buying a flawed good.  Alibaba’s example is only the most recent, egregious example.  Folks buying these shares aren’t actually investing in Alibaba at all: they are buying shares in a Cayman-domiciled company, which has a financial interest in Alibaba’s profits.  Furthermore, the agreement between the Cayman company and Alibaba is still under review by Chinese courts; if the agreement is nullified, there may not be any economic value of these shares.  A head-scratcher…

In 2010, Netflix seemed to be gaining 1% or so every day.  Coworkers would ask me whether I’m buying shares.  My answer?  Absolutely not.  Not only were the shares trading at a ridiculous price/earnings multiple; the shares themselves had few rights corporate governance-wise, with a massive share overhang from the private equity companies holding shares and insiders.  I slept better without the gains, knowing the shares could be a powder keg.