Closing a capital gains tax loophole: Piketty-lite for the US

One of the policies President Obama outlined in his State of the Union speech was eliminating (to an extent) a pretty sweet tax loophole: the tax-free cost-rebase of assets passed following the owner’s death.

For example, consider hypothetical farmer Joe’s (age 85) farmland he bought decades ago for $100/acre: suppose the fair value of the land is now $5,000/acre (probably an understatement).  If Joe sells his farmland, he owes capital gains tax on $4,900/acre.  Suppose instead, Joe dies this year and the farm passes to his only child: the farm passes to the child tax-free, and the child’s ‘cost’ for the land is now $5,000/acre.  No capital gains tax to the government.

The above situation seems OK-ish in the family farm arena: as a society we shouldn’t force poor Joe’s child to sell the farm to pay tax, should we?? Well, consider that this same process/economic policy applies to HUGE farms, buildings, houses, stocks, bonds, etc. etc.  For example, the same story would occur if Joe was a very wealthy ex-CEO with a shareholding of $100 million.  Estate tax would be owed, though wealthy Joe would probably have found some ways of mitigating that.

Anyway, this policy proposal sounds a bit like the rant I wrote a while ago, about making a serious effort to equalise opportunity; to me, the most justifiable/fair redistribution would happen at death of the elder generation, to improve opportunity for the younger generation.  As a side benefit, having punitive death taxes would probably encourage consumption, which is generally helpful for redistribution (i.e. the rich save more than poor, so getting them to save less is likely a good thing overall).

As was written in the Economist, this policy idea will likely go nowhere fast.  However, their chart of where these long-term capital gains end up hopefully helps illustrate the point that indeed, these gains would be an effective source for redistributive taxation.  Hold off the pitchforks!!

Who gets the gains? They do! Source: Economist.com

The S&P 500 – Old school chart patterns

I’m intrigued by the recent congestion in S&P 500 prices.  Up and down it goes.  Here’s a chart of the past 6 months-ish:

Mirror, mirror on the wall… Source: thinkorswim by TDAmeritrade

Unlike the relative smoothness of trends in the past, we’re now in an undecided market.  According to (very) traditional technical analysis, I reckon this could be a sign of multiple chart patterns:

1. Head and shoulders top: see here.  The recent run-up might negate, but still seems to signal further downward move.
2. Double top: here.  Is 2060 on /ES the top, and we’re on our way back down?  Or maybe we need another run to 2080 to verify the old top, before heading back down?
3. Triple top: here.  Maybe we can say the runs to 2060 are just 2 more tops added to the 2080?  In which case reversal time?
4. Falling wedge: here.  Perhaps we’re seeing the high/low runs compressing in a falling wedge, indicating a possible upside breakout?

So many people sign up to newsletters (some of which are very exclusive (read: expensive)) which purport to have amazing chart pattern analysis.  Others buy expensive chart pattern software.  I’m clearly a dunce, as I can’t figure out whether one pattern is better than another in the case of the S&P today.  Assuming complete ignorance, I could equally weight the above observations and come out on the side of a continued fall in S&P prices.  I place roughly 50% confidence in my assertion – so less than the weather forecasters who predicted at least 2 feet of snow in NYC yesterday.

In sum: back to the drawing board.  Not literally – probably won’t use hand-drawn lines to guide my trading anytime soon.

Greek elections: The difference between known- and unknown-unknowns

I win! Now what? Source: Reuters

Congrats to the protest voters in Greece’s election on the weekend, with the anti-austerity Syriza party taking a majority position in their parliament.  A few thoughts:

• Now what?  The story of Syriza brings to mind the Tea Party in the US.  It started as a small protest party with extreme views – a simple message of ‘We can’t handle this debt burden that was left to us.’  Now that the party is in control, simple messages don’t work as well for continued governance: for example, Tea Partiers became very selective in which debts were OK to keep (Social Security and Medicare, mainly).  The press has already picked up on the challenge for Syriza going forward, as they figure out how to balance the simple message with realpolitik.
• Markets priced the news well.  Yes, the Euro crashed for a little bit.  Stocks took a little hit.  But within hours (at least as I write), we’re practically back to where we were before the election.  So the market did a great job of pricing this known unknown: the winning margin of Syriza in Greece, and how aggressive they’ll be in renegotiating their debt burden.
• Contrast with SNB manoeuvre.  The weekend news provides a good foil for the SNB move a couple weeks ago: that unknown unknown meant the markets had no time to price expectations.  On the plus side, market efficiency meant the prices moved quickly to reflect new info.  On the minus side, those discontinuous moves brings much heartburn to investors/traders.
• What would you do?  Suppose you’re in a big position of power, and you have big news to communicate to the markets.  Do you drip in the info, like Super Mario and the ECB?  Or do you shock and awe, as the SNB did?  Markets clearly prefer the former, but maybe there are reasons for the latter method.
• The bigger message.  I wonder if this qualifies under ‘folks with pitchforks’, when we talk about the demise of the Western middle class.  Now protest parties (e.g. Podemos in Spain) are expected to get a lot more votes, which will bring similar uncertainties.  Without being too ominous, the status quo seems to be unravelling.

VIX futures calendar spread strategy: a little data mining

Has anyone noticed a bit more volatility in markets these days?  That SNB shocker was something, indeed – it seems some FX retail brokerage houses have already declared insolvency.  Anyway, the increased volatility has had quite an impact on VIX in the year so far: after starting the year at an elevated, yet respectable 17-ish, the index has climbed to a panic-like 22.5.  For those stats-minded, that latter figure implies a daily move of around 1.4% for the SPX – not unusual recently, but pretty darn high compared to post-2008.

OK, let’s get to work.  The VIX is very elevated, but it can be a mug’s game to short (i.e. the VIX can get smashed a bit like the SNB smashed the Euro/CHF exchange rate yesterday).  Too risky for an outright short.  What to do?? A VIX calendar spread.

Mmm…spot the backwardation. Source: thinkorswim by TDAmeritrade

• Hypothesis: times of high volatility causes the VIX futures curve to go from contango (e.g. further months more expensive than near months) to backwardation (the opposite).  When the market returns to more normal conditions, the contango will return.
• Method: when the futures curve goes to backwardation, or very near it, go short a near-month future and hedge by going long a further-dated future.  Take off the trade when contango returns.
• Which contracts?  Note the curves in the picture.  The red line is today’s VIX futures curve – e.g. flat to backwardated.  The other lines are the month-end VIX futures curves for the past 6 months.  A couple observations:
  • In normal markets, there is a pretty smooth contango.  So the max return for any 1-month calendar spread is about the same going out 6 months.  You could choose, say, months 2/3, 3/4, etc.
  • However: notice how much extra movement occurs in months 1 & 2, say, relative to further months.  So, it’s a risk/return situation: if you want higher risk/return, go for earlier months.  I, being a chicken, will stick with a bit less risk – months 3/4, perhaps.  That means I choose to be short Apr 2015, hedged by long May 2015 futures.
• A bit of data mining to convince me: I downloaded the month 3 and 4 continuous contracts from Quandl, then did the following rough analysis:
  • Time range: 1 Jan 2008 through yesterday, daily data.
  • Metric: gross profit from Month 3 and 4 calendar spread, assuming a 1-month hold (i.e. mechanically holding the position 1 month).
  • Brief, dirty stats:
    • Unconditional (e.g. all daily observations)
      • Observations = 1740
      • Mean gross return = $0.006/spread
      • Expected return, using uniform probability distribution and decile returns (including min/max) = $0.033/spread
      • Z-test for mean different than 0 = 36.8%.  In sum, I can’t assume the expected return is positive.
    • Conditional (e.g. only enter trade when spread is $0.05 or less)
      • Observations = 454
      • Mean gross return = $0.341/spread
      • Expected return, same method = $0.320/spread
      • Z-test for mean different than 0 = less than 0.01%.  In sum, I can assume a positive return.
• Summary: I think this strategy will work in the current environment, so I’ve put on the trade in small size to test the waters.  Wish me luck!

Gadzooks! Which is the safest of them all? Clearly Swiss Francs…

This is one of those moments most currency traders and macro hedge funds feel REALLY sheepish/scared:

That’ll hurt: Swiss Franc futures reverse mightily. Source: thinkorswim by TDAmeritrade.

Imagine the situation:

1. Beginning: the Swiss Franc seems a safe play.  Very carefully managed by the Swiss National Bank (SNB), which REALLY doesn’t want much variation in their safe-haven currency, you assume a stable relationship.
2. The initial trade: Swiss interest rates are very low – in fact, negative.  This sets up the proverbial carry trade – borrow in Swiss francs to fund a bet in any currency.  Let’s just use the USD, as it has a terrible low interest rate too, but is still pretty safe.  So you pick up 50bps (around 0.25% in the US, set against -0.25% in Switzerland) in a pretty safe pair.
3. Life is good: this interest rate differential is picked up in the futures through the near-continuous downward trend we see in the chart above.  Ahh, relax and go short this futures contract.
4. Today: Oh Shit.  The SNB decides enough is enough, and stops putting a floor on its safe-haven currency.  Interest rates move to -0.75%, so your carry signal says stay short the contract.  But the underlying moves about 30% against you, negating about 60 years worth of the old carry returns.  Oh dear.  Hopefully you didn’t cash out at the worst point, as the pair has only moved about 15% at this point.
5. Statistics?!? Who cares?  The implied volatility of the future has been around 10% p.a., or around 0.7% daily.  So a 30% daily move is about…45 standard deviations.  We’re talking infinitesimal probabilities.
6. When writing uncovered calls really sucks.  God forbid you had a system of writing calls to collect the carry here.  Suppose you wrote a $1 call on the contract above yesterday, giving yourself a bit of room on yesterday’s $0.987 close to collect the carry.  Your premium? About $.005 for a 30-day option, which is now MTM at about $0.124 (essentially delta=1 here, so whatever the difference between $1 and the current market price).  Your loss is about $0.12 per contract, or $15,000.  So you collected $625 in premium to now need to post $15,000.  Ouch.

In sum: I’m sure we will find out about certain funds which collapse from this type of trade, or those who trade against consensus and made a ton.  I am very happy not to have been playing this currency.  For option traders – this is the reason you use defined risk trades: yes, you give up a fraction on every trade you do, but it can save your bacon when things like this happen.

Wow.

Political and economic sense…a difficult combo

The soundbite was good, but sadly not economically sensible. Source: Google Images

Going into this year’s UK general election – or the 2016 US Presidential election, a common thought I have is ‘why can’t politicians make economic sense with their policies’.  Some things, such as the looming pensions crisis or tax policy, just don’t get much airtime for trifles such as an actual accounting of economic impact.  These are generally left for agencies such as the IFS in the UK to communicate, which folks typically ignore.  Political parties seem to understand this well enough, so don’t engage in enlightened debate.

Anyway, my old colleague Rob has written a great treatise on this issue on his blog (link to the blog at right).  Thanks for the useful analogy, Rob.

Hedge funds: haters gonna hate

Much in recent press arguing against hedge funds.  Probably related to news of another large pension fund divesting completely.  Plenty of vitriol around; a good summary of why not to invest in HFs from Barry Ritholtz is here, which further sources material from FT regarding ‘zombie funds’.

Let me highlight a couple reasons I’m still happy to invest in hedge funds:

1. Problem with averages + performance persistence = opportunities.  I recently wrote about how alternative asset managers (including HFs) show much more persistence in returns, unlike conventional asset managers.  Thus, as often thrown in as a throwaway comment in the articles above, there are managers out there which consistently beat the averages to provide attractive returns.  Unlike picking the best-performing long-only equity manager, hedge fund managers tend to show more consistent outperformance.
2. Risk premium diversification, at needed risk level.  Though most articles focus on how not diversifying hedge funds are as a group (probably because HF indices tend to have a massive overweight towards Long/Short equity and credit, which have high correlations to long-only equity), there remain several investment strategies which provide true diversification (e.g. managed futures/CTA).  Though some of these diversifying strategies are available in more conventional form – e.g. through an ETF or mutual fund – I appreciate the additional capital efficiency provided by higher-risk versions in ‘proper’ hedge funds.  More of a barbell approach to alternative investments (an aside – here is a new paper by Nassim Taleb et al. regarding mathematical justification for a barbell approach).

In sum: hedge funds can be massive wastes of fees, particularly if their performance starts to look very much like long-only equity.  However, even a small bit of due diligence can yield solid managers with solid track records in solid diversifying strategies.

Persistence in investment manager performance – can he/she keep it up?

We’re now in year 7 of an equity bull-market; those patient and/or lucky enough to have bought the S&P 500 early-March 2009 are now up about 200% on their capital invested.  Each year, since 2009, seems to be the same story of ‘death of hedge funds…long live cheap equity ETFs’.  Linked to this idea is the underlying concept of performance persistence – how likely is good performance observed in past indicative of future performance?  Before shrugging off the previous question with the ubiquitous ‘Past performance is not indicative of future returns’, let me make a few observations on persistence, some of which are likely different from what you’ve come to expect:

1. Persistence as link to risk premia: suppose we have an underlying risk which is investable – e.g. economic growth, inflation, credit worth.  If the underlying risk remains (e.g. the economy continues to grow), while folks remain uncertain about the extent and timing of the risk (e.g. some believe the economy is about to crash, versus others who believe it will continue growing), we should reasonably expect persistence in the risk premium over the very long run.  Solution: invest in risk exposures (‘betas’) for the very long run, e.g. long equity ETFs.
2. Persistence among long-only asset managers: suppose we’re considering buying equities; now we wonder whether to put all long-equity investment into basic ETFs, or give some to long-only managers.  After all, several guys seem to have done very well, relative to the broad market, so can’t we pick well?  The answer is generally no, you are very unlikely to pick a long-only manager well.  In several studies – including this one – long-only manager skill is shown to have near zero persistence.  That means, while it’s possible to choose the rockstar manager for a short period of time, over the long-run you’ll likely end up with mediocre or worse returns versus the benchmark.  Solution: stick with pure index ETFs for long-only exposure.
3. Persistence among alternative asset managers: now suppose you’re looking at alternative strategies, such as hedge funds, managed futures or private equity.  In contrast with #2, there is persistence in alternative manager alpha (e.g. see here).  With many hedge fund sectors, the best relative performers in the past remain so in future.  Solution: assuming everyone is accepting new capital, feel free to use historical track record relative to peers, when choosing alternative asset managers.
4. What am I not saying? I’m not characterising persistence here as something magic – e.g. a 10% gain last year implies a 10% gain this year, or something like that.  Persistence mainly revolves around the very long term, with the noisiness of markets wiping out observed persistence over short time spans.  So the ‘Past performance … ‘ statement is absolutely correct in that, for example, we shouldn’t expect performance from fixed income long-only funds to be anywhere near as strong as in the past; the market conditions just aren’t there right now.  However, the underlying risk premium which fixed income funds exploit isn’t likely going away in the long term; there will likely be more gains to come for these funds.

In sum: keep those long-only ETFs as a basic exposure to (persistent) risk premia.  Don’t bother with rockstar long-only asset managers… you’ll likely be disappointed in the end.  Past (relative) performance for alternative asset managers seems to have more persistence, so feel free to use historical track records as a data point when considering these guys.

Hail to the quants…

I’ve written before about the merits of systematic trading…indeed I do a bit myself, in addition to investing with some quant shops.  Anyway, looks like they had a better year in 2014 than most stock pickers.  Congrats to those who have been long-term patient with the momentum traders – as expected/hoped/implicit in momentum strategies, years of lacklustre performance (e.g. 2009-2013) were more than compensated by 2014’s returns for a great many funds.

This leads to both Q & A:

• A: I distinct recall speaking with many existing/potential investors in managed futures/systematic trading, in which the question was asked: is momentum dead?  Are the systems broken?  Hopefully 2014 helps answer that.
• Q: is the performance of 2014 sustainable?  For example, 2008 was a great year for the strategy, with a bad year in 2009.  So will 2015 be like 2009?  I wish I knew, but for the moment I’m staying invested.

The retirement crisis in America: an online film worth viewing

I stumbled across the Broken Eggs website from Marketwatch today, and immediately accessed the (free) online film.  The trailer looks very promising: a good mix of statistics and personal stories to make the issues surrounding retirement in the US a bit more understandable.  Though not mentioned (as far as I’m aware….I’m about to sit for the film), we can practically replace the US in the film with any other developed country (aside, maybe, Norway); the issues are the same.