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01/04/2022

Is this why cryptocurrencies are better than gold?

In October, I wrote a post about the fiasco that was Amazon’s New World game. They accidentally created a world where the supply of currency was limited and could not be increased. The result was a massive deflation and a collapse of the economy in that virtual world. I compared this scenario to what would happen if we return to a fixed gold standard or adopted a cryptocurrency like Bitcoin with its limited supply as standard.

As with every post I write about cryptocurrencies I got lots of responses from crypto advocates (and in this case also from gold advocates). The basic argument of gold advocates is that gold supply increases by a few percentage points each year from gold that is freshly mined. My counterargument is that this is true, but if you want to fight the collapse of an economy, you have to be able to temporarily increase the supply of money dramatically in order to prevent a run on banks or hoarding of good money (see my remarks on Gresham’s Law in the previous article). And economic crises don’t care if gold mines can produce enough output or not. So, a gold standard will inevitably lead to a deflationary economic collapse. This is why central banks had to abandon the gold standard in the Great Depression and why the financial crisis of 2008 would have been as bad as the Great Depression had we still been on the gold standard then.

But the crypto advocates had a different argument and one that is seemingly better. They argued that cryptocurrencies can adjust their supply with relative ease to react to changing demand. This is not true for Bitcoin with its stable demand, but it is true and actually happened for Ether. On 5 August 2021, the Ethereum Improvement Proposal 1559 (EIP-1559) was put into action. Since then, every new transaction that is included in the Ethereum blocks levies a base fee that is eventually destroyed. This means that the supply of new Ethereum tokens is curtailed by the base fee, thus creating a reduction in supply growth. This was done to prevent oversupply of Ethereum since this digital currency has no upper limit to how many Ether can be mined. But the same mechanism can be used in reverse to create additional supply should there be a need for it. Essentially, with a small coding change, the supply of Ethereum can be adjusted upwards or downwards at a moment’s notice.

This is great and should prevent a New World style deflationary collapse.

But assume we are using Ethereum as the standard currency. Who is going to decide when and by how much to increase or reduce the supply growth of Ethereum? The current methodology of democratic decision making about EIP is far too slow and too cumbersome to work in an emergency. Besides, assume that the UK adopts Ethereum as its currency. If the people in the UK decide that they need a higher supply of Ethereum but a majority of Ethereum holders in the world (most of whom will not be British or even live in the UK) decide that this is not a good idea, these foreigners can dictate monetary policy that applies to the UK. A democratic process run by owners of Ethereum worldwide clearly doesn’t work on a national level.

Thus, what one needs is a cryptocurrency that is controlled by the British and able to make fast decisions if there is an economic emergency. In order to make a quick decision one needs a group of experts that is competent enough to make the right decisions in the best interest of the people and that can act fast enough to implement changes in the supply of the cryptocurrency. And because they need to be able to act in the best long-term interest of people instead of every whim and populist call for more money, they should not be elected representatives of the people. We see in so many countries what happens if you elect populists.

But wait, don’t we have such a group of experts that are able to make quick decisions about the supply of currencies without being exposed to populist tendencies? Yes, we do. They are called central bankers. It is the reason why we have central banks in the first place because for centuries we have tried other ways of managing the money supply and they all failed. And this is why I am supportive of central bank digital currencies but not the dreams of cryptocurrency optimists who think that a decentralised currency will somehow be able to better for our economic wellbeing. I have not seen any solution to the problem of dealing with economic emergencies like the financial crisis, the Great Depression or the New World deflation crash coming out of the cryptocurrency world that is even remotely realistic. And I doubt there is one.

31/03/2022

Sector neutral or not?

Professional investors have a knack for optimising everything. For example, while most retail investors don’t really care what kind of sector exposure they have in their stock portfolio, professionals debate whether they should be sector-neutral vs. a benchmark or not when selecting value stocks for instance.

If you follow a certain investment style like value investing you want to invest in “cheap” stocks. But what a cheap stock is depends very much on your frame of reference. A tech stock can be cheap relative to other technology stocks but expensive relative to the market overall. The result is that if you simply screen for “cheap” stocks in the market, you tend to get results with a different sector composition than the market has. The chart below, for instance looks at the 25% best stocks in the UK and then compares the resulting sector composition with the sector composition of the UK stock market. For instance, if you are a value investor and look for the 25% cheapest stocks, you will end up with a portfolio that is heavily overweight consumer discretionary, energy, financials, and real estate and underweight basic materials, consumer staples, and healthcare.

That’s great at the moment when energy prices are rising and banks benefit from higher interest rates, but for the longest time over the last decade that kind of sector exposure would have held back the performance of value investors. Which is why fund managers often approach a portfolio with a sector-neutral approach in order to get rid of these sector differences that can significantly contribute to both outperformance and underperformance vs. the market.

To old-fashioned value investors that sounds like heresy because Ben Graham never cared about his sector exposure. If a company was cheap it was cheap, no matter what sector it was in. But the reality is that we live in a world of benchmarking, for better or worse, and that means that fund managers that deviate from the benchmark in unintended ways risk getting fired by their investors simply because they are straying from the benchmark too much.

But does being sector-neutral help or hurt a portfolio’s performance? That is the question the always great Campbell Harvey and his colleagues set out to answer. And they chose a very simply and straightforward approach. They simply measured the return and volatility of a given strategy (e.g. value) in each sector and across the long and short side of the trade. Then, they essentially considered a straightforward value strategy as a portfolio of these sector-specific value strategies. Whether the combination of different sector-specific strategies yield better performance across sectors is then a matter of the risk-adjusted returns of each sector-specific strategy and the correlation between these returns.

Using data for US stocks from 1963 to 2020 their research found that in a long-short portfolio it is best to be sector-neutral because the contribution from cross-sector bets on the portfolio is much smaller than the contribution from within-sector bets. But for long only investors – and that is pretty much every traditional fund out there – their research finds that it is highly unlikely that a sector-neutral strategy will perform better than a strategy that incorporate sector bets. The reason is that in a long only environment, the contribution from cross-sector differences in valuation or other metrics is almost as high as from within-sector differences. This means that most fund managers are better off taking active sector bets and not bothering about their benchmark. Of course, that may expose them to criticism from investment consultants, but as most professionals know, these investment consultants are not good at creating returns for investors anyway.

30/03/2022

Palm reading, investment edition

Take a look at your left hand, palm facing towards you with your fingers next to each other. Keeping your fingers straight, which finger is longer on the left hand: the index finger or the ring finger? Now do the same with your right hand.

Measure the length of your index finger vs. your ring finger

If you are a man, then in about 50% of the cases your index finger will be shorter than your ring finger, in about 25% of the cases, your index finger will be about the same length as your ring finger and in the remaining 25% your index finger will be longer than your ring finger.

If you are a woman, in some 30% of all cases your index finger will be shorter than to your ring finger, in about 25% of the cases they will be roughly the same length and in about 45% of all cases your index finger will be longer than your ring finger.

Now look at the chart below which shows the average willingness to take risks in life in general. People with an index finger that is shorter than the ring finger tend to have a higher willingness to take on risks than people with an index finger longer than the ring finger.

Attitude towards risk taking and length of index vs. ring finger

The results above are from a survey of thousands of Americans by Brian Finley, Adriaan Kalwij and Arie Kapteyn. But these are not really new results. This study found that traders with an index finger that is shorter than the ring finger are more successful and stay in their career for longer. And this study showed that people with an index finger shorter than their risk finger are also more prone to follow bubbles and are more likely to be trend-following investors exaggerating market moves.

Huh?

What one needs to know is that the relative length of the index finger vs. the ring finger is determined by the exposure of an embryo in the mother’s body to testosteronev. If an embryo is exposed to more testosterone during its early development, its body and brain cells develop a different sensitivity to these hormonal signals that stays with the person for the rest of his or her life. On the one hand, people exposed to more testosterone tend to build up more muscle mass and have an easier time building muscle mass through workouts and training. So they tend to be better in sports as grownups. Meanwhile, their brains tend to get used to a higher level of testosterone as a base level which means that the body keeps up higher testosterone levels throughout their lives. And because testosterone modulates and influences the fight or flight functions in the brain, people with higher testosterone levels tend to be more aggressive and take more risks in all kinds of domains in life – including investments.

29/03/2022

More bad news for active fund managers…

I am sorry to darken the mood of all the active fund managers who read this, but current high inflation will be felt by them in coming months.

Inflation has been running hot in the last six months in the United States and other countries. Here in the UK, we are debating the impact of the “cost of living crisis” on consumption and similarly, one would expect that high inflation could lead to lower consumption in the United States as well, though the recent retail sales data clearly shows a strong consumer at the moment. A key driver for lower consumption going forward may be high prices for fuel that are felt across the entire economy. And at the end of 2021, energy inflation in the United States reached 30% compared to the previous year.

But if households have to spend more money on the items of daily life they have to find that money somewhere and that usually means cutting back on other cost factors – particularly those that are easy to cut.

With the advent of index funds, one area where it is easy to cut costs is fees for investment products. You can simply take your money out of higher-fee actively managed funds and shift it into lower-fee passive funds. And according to a new study by Swasti Gupta-Mukherjee and Hae Mi Choi from Loyola University that is what seems to happen. They found that if quarterly inflation rates for US energy goods and services spike above 4%, then every additional percentage of quarterly energy inflation increases outflows out of actively managed mutual funds by 0.33% on an annualised basis. Note that in the fourth quarter of 2021 the quarterly energy inflation rate rose to 8.3%, so outflows out of actively managed funds may have accelerated by 1.5% annualised. In times of low energy inflation, the effect is much smaller, in fact about two thirds smaller. If inflation is below 4% every percentage point increase in energy inflation increases outflows by 0.1%.

But this money isn’t just leaving actively managed funds and the stock market altogether. The research indicates that investors are not abandoning stocks in times of high energy inflation but are moving into low cost passive investments to save fees. While actively managed funds experience substantial outflows in times of high energy inflation, passive funds see accelerated inflows and the gap in flows between active and passive funds becomes larger during these day.

As energy inflation remains high during this winter this is bad news for active fund managers, but there is light at the end of the tunnel. Energy inflation is likely to decline throughout the rest of 2022 which should ease the pressure on investors’ wallets.

28/03/2022

The beauty of simplicity

Just before Christmas, I made myself a Christmas present and got my new Polestar 2 electric car. I always liked that car because while it is very similar to a Tesla Model 3 it is essentially a Volvo underneath, which means it has a much better build quality. But more importantly, it is a thoroughly well-designed car. Not only is it good-looking, but everything in it is properly thought through to the point where you start looking at other cars thinking to yourself: Why do they do that?

The last time I can remember having a similar experience as in this car was when I first came across Google more than 20 years ago. For those of us old enough to remember a time before Google, you might remember the interface of search engines like Altavista, Lycos, or Yahoo. Essentially, they were cluttered full of ads and links to individual sub-sections. Below is a comparison of Altavista in 1998 with the Google Beta version from the same year.

The simplicity of Google was a key differentiator. You had one search bar and that was it. And it worked. No fuzz, no distractions.

Ironically, my Polestar 2 does the same thing with the interior of a car. And it does so, by being entirely built around Google’s software platform.

My prime example is the driver dashboard. Every car I have driven in the past had a lot of information on the dashboard. From the fuel gauge to the rev counter to the speed information, etc. And as cars become more and more like computers, more and more warning lights, indicators, and information was displayed on the dashboard.

Not so in my new car. The dashboard contains information about the speed you are going on the left together with the gear you are in (which can vary between R, D, and P, nothing else). And on the right I the battery charge level and the range. That’s it. If you put on the GPS, the middle section is filled with a little pictogram that shows you the next turn. If you really want to have more information you can display the entire Google map on the dashboard and if you set the cruise control the set speed is displayed as well, but otherwise that’s pretty much it.

You have no idea how relaxing it is to have this kind of decluttered display. Every time I check my speed or the range while driving, I don’t have to search the info in a sea of data and indicator lights. It is right there. It may sound stupid because the time saved is maybe one or two hundredths of a second, but I can literally feel the difference. I never really noticed how my body and my brain tensed up ever so slightly when looking at the dashboard or the driver display in a car. But now, whenever I get into another car and start to drive it, I can feel how the dashboard and display stress me out – something that doesn’t happen in the Polestar and that makes driving it so much more relaxing and convenient.

Other details are similar in nature. If I turn on the indicators, they make a very different sound than indicators in other cars. It is no longer the high-pitched clack, clack of other cars, but a deeper, warmer sound that caresses your ears. Now I am actively looking forward to every opportunity I have to turn on the indicators. Somehow, the design of that sound has increased the safety of the car because I indicate more to my fellow drivers.

Ok, enough now. This is already too much praise for my new car, but the point I am getting to is that good design is design that works and makes your life easier, not something that shows off the technical prowess of the person who built it. In essence, good design follows Dieter Rams’ principles from the 1970s:

Good design is innovative

Good design makes a product useful

Good design is aesthetic

Good design makes a product understandable

Good design is unobtrusive

Good design is honest

Good design is long-lasting

Good design is thorough down to the last detail

Good design is environmentally-friendly

Good design is as little design as possible

In the financial industry, we are doing exactly the opposite when designing financial products. Actively managed funds increasingly use derivative overlays to “optimise” performance, ETFs get into ever smaller and exotic niches of the market (Millenial Consumer ETF or a Fallen Knives ETF anyone?). And don’t get me started with structured products…

Similarly, in asset allocation, we are pushing towards more and more exotic alternative investments because we expect equity and bond returns to be lower in the future than they were in the past and we are looking to diversify the dreaded risks of a bear market.

There is nothing wrong with adding alternative assets to a portfolio, but why make it more complicated than necessary?

Here is a proposal for a simple and in my view good design for a portfolio:

Decide which asset classes you want to invest in and then put an equal amount of money into each of them. Think of Harry Browne’s Permanent Portfolio which is one quarter in stocks, one quarter in long-term bonds, one quarter in short-term bonds or cash, and one quarter in gold. Personally, I like to have real estate in my portfolio as well, so I would go for 20% each in stocks, short-term bonds, long-term bonds, gold, and REITs, but that is a matter of taste.

Similarly, if you are running an equity fund, so many fund managers try to put different weights on different stocks reflecting the size of the opportunity or the conviction of the manager. Don’t do it. There is ample empirical evidence that a simple equal-weighted stock portfolio outperforms a more complex optimised portfolio in the long run. 15 years ago, Victor deMiguel and his colleagues caused a sensation when they systematically showed how much better equal-weighted portfolios are in real life than optimised portfolios. Since then, thousands of papers have been written trying to debunk or confirm these results., The verdict is still the same: Equal weight works extremely well.

When I manage equity portfolios, I use 20 or 30 stocks that I equal weight and then rebalance regularly. That’s it. And it works. But not only does it work, it removes mental load and stress from me as an investor. I don’t have to think about whether to invest a percentage point more in one stock and take a percentage point out of another stock. And I don’t have regrets if I have a stock that does much better than I thought it would and I hold it with only a small weight in my portfolio. Picking stocks and managing a portfolio is hard enough. But if you design it well, it can be much less stressful and much less work without giving up performance.

Of course, recommending such a simple well-designed portfolio to an investor will probably raise eyebrows. “If it is this simple, why do I pay you a fee in the first place? I can just as well do it myself or pay you less.” Complexity is a simple defence against fee pressure. But it is just a matter of time until your clients become wise to you and your complex gimmicks and will abandon your product for a cheaper, simpler one. Personally, my response to a clients’ question asking why she has to pay a fee for an equal-weighted portfolio is this old parable:

There was once a rich businessman with a broken beloved car. Despite several attempts, he was unable to fix the engine of that car. He called several engineers but no one was able to fix it. Finally there was an old mechanic who visited him. That old guy inspected the engine and asked for a hammer. On front side of the engine, he tapped few times with his hammer and brrroomm…brroom…It started Working! Next day, the old mechanic sent his invoice for $1000. The businessman was shocked.

He said, “ This was merely a $1 job. You just tapped the engine with your hammer. What’s there for $1000 that you are asking?”

The old mechanic said “ Let me give you a detailed invoice.”

The Invoice read:

Tapping the engine with hammer: $1

Knowing where to hit the hammer: $999

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