The US Government Is Making Lots Of ‘Bad Trades’

Capricorn wind farmThere are two types of bad trades.  The first is the mode-mean trade where the mode is positive the mean zero or negative.  One shouldn’t make this kind of investment, because at best it simply adds noise to one’s portfolio.  The net return to the passive investor can be especially negative because often they mistakenly overpay for management, not anticipating the drawdown, and the agent does not payback old profits when this is all revealed. Such trades are common in financial markets, and savvy investors are very aware of them.  Junk bonds, writing out-of-the-money options, hurricane insurance, are good examples. 

Another type of bad trade is where losses are expected initially, but supposedly it’s just a learning curve or scale issue, and eventually once all the ducks are in a row the positive cash flow supposedly appears.  These are more common, as with any high frequency trading strategy that burns transaction costs, not realizing that those close-to-close returns used in the back tests weren’t realistic estimates of feasible net fill prices. 

The more money an investor has tied up in such trades the lower their total return over the long run. You can try to avoid them, but a better priority is to simply identify them and flush them when they reveal themselves. That is, getting out of bad investments is probably the single most important thing an investor can do,as opposed to finding alpha, which is simply much harder.

Our economy has many such bad trades going on at any one time, and the sooner these are abandoned, the quicker people will reallocate their time towards something that actually costs less than its revenue.  Consider guarantees to farmers, which supposedly allow farmers to withstand the vagaries of weather, ensuring our very survival.  We have policies that encourage producer cartels, direct payments via subsidies, paying farmers to not farm, disaster aid, insurance subsidies, and export subsidies and import tariffs. So now farmers who suffered from the recent drought directly get fully insured payments, and those who avoided it get the revenue from higher prices.  This isn’t helping us become more efficient farmers.

Then we have clean energy, education, defense, high-speed rail, all costly investments that potentially will pay off big eventually, but in practice are subverted by special interests into a focus on producers not consumers.  If the negative present value were revealed via the negative cash flow at market prices, an efficient response would be to reallocate capital and labor. Instead, these activities are propped up under the hope that mere time will allow some sort of critical take-off point in future productivity. 

Many like to deride the short-term nature of markets, but the long-term rationalizations of top-down industrial planning is much worse.  It’s not like our non-market economy is allocating capital like Berkshire Hathaway, rather just a series of patches to problems created by prior programs. 

The best way to increase productivity is to stop doing things that have negative NPVs because these have massive opportunity costs, and this is best reflected by the true discounted cashflow sans government in its myriad forms. Obviously this is a pipe dream, but it’s an example of the way government can help the economy and reduce spending simultaneously.

There would be some costly adjustments, but as they say, when you are in a hole, stop digging. What is prudence in the conduct of every portfolio can scarce be folly in that of a great kingdom.  

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GMO’s Inconsistent Defense Of Equities

Pimco maven Bill Gross recently warned that both equities and bonds look headed for a bad intermediate future.  He makes the interesting observation that as labor income has declined over the past century, this allowed capital to reap more reward than what is merely in GDP growth (see above chart).  Yet, this cannot continue any more than bonds can appreciate from lower yields.  The result is pretty scary, because as Gross points out, a 4.75% asset return premium needs about a 7% growth from equities if bonds are going to generate 2% returns, and if this won’t happen, CalPERS and many of its ilk are in serious trouble.


Ben Inker of GMO Equities should not be thought of as residual claims on an economy, but rather the peculiar returns to an asset class in a very complex equilibrium.


Consider the first-day returns on IPOs, which have averaged about 12% historically. This is obviously a huge return for those fortunate enough to get such shares, but unless you are Nancy Pelosi, or an investor who perpetually overpays for commissions, you don’t get that one-day pop. That is, the investment banks capture this return by making investors overpay (or grant regulatory favors), so non-politicians don’t capture any of this net net. The net money always goes to insiders, not passive investors, in hedge funds, corporate equity, corporate bonds, etc. Those big passive equity funds are like kids showing up to a trendy club and finding out that you need more than money to get in, you need connections, something unique to exchange.

As commissions and spreads have declined, the insiders are not making as much as they used to, so they can’t afford to give away big returns to top-line stock indices. On top of low current long-term bond yields, this suggests weak equity returns going forward.

But then Inker returns to the intuitive theory of karma, and argues that equities have to generate a 6% real premium to compensate for the fact they are riskier than cash, noting their high volatility, and draw-downs during famously bad times like the Great Depression, WW2, and various financial crises. Yet it is pretty clear that risk is not correlated with higher returns within a variety of asset classes, such as equities, corporate bonds from BBB to C. Even GMO accepts this fact. Many people believe in a fundamentally inconsistent asset market: broad asset classes generate risk premiums that don’t exist within these asset classes.

My solution, out in a book soon, argues this is because passive investing has zero risk premiums everywhere, when you look at assets in total. In any case, whether you believe in a large equity premium or not, there appears little reason to be in those highly volatile classes, unless you are like most people and overconfident about your stock picking abilities. This little conceit facilitates a rather large cluster-puck of mistaken assumptions, and I’m afraid most people will take the wrong lesson (eg, Joe Nocera’s latest screed against shareholders), which if heeded will just aggravate our tendency towards more giant corporations with governmental influence, privileges, and resulting decreases in efficiency and competition. That will hurt GDP growth.

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This California School District Deserves To Go Bankrupt

poway californiaWhile banks are still being persecuted for lending too much and not lending enough, too many still are getting money they shouldn’t.  Case in point, a San Diego school district

In 2008, voters had given the district permission to borrow more money to finish its modernization, and they had received a big promise from the elected school board in return: No tax increases… the district got creative. 

With advice from an Orange County financial consultant, the district borrowed the money over 40 years in a controversial loan called a capital appreciation bond. The key point for the district: It won’t make any payments on the debt for 20 years. … 

“We could have authorized more taxes, it would just have been breaking the promises we made to the community,” said school board member Todd Gutschow.

This works great if you plan on dying within 20 years, but otherwise it’s not very smart. As Reason writers Veronique de Rugy and Nick Gillespie write in The Hill, neither party is working honestly to tackle the nation’s fiscal issues, in large part because it doesn’t sell to voters. I see a train wreck, and so the sooner it happens the less disastrous it will be.

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You Won’t Be Impressed With These ‘Insights’ From The Next Generation Of Economists

Nicholas Bloom

BigThink asked some great young economists about big ideas in economics. I’m not very sanguine about any of these guys finding something important very soon. It starts with Paul Krugman, lamenting that:

The central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Krugman got his Nobel Prize for a mathematically elegant model of international trade. There was no new, true and important insight of that model, it was merely an elegant rationalization of some stylized facts that has zero predictive power and is 99% orthogonal to anything he himself actually discusses about economics. I glad to see he sees the pointlessness of such parochial models. Will he give back his Nobel Prize?

Here are some great insights or projected intellectual trends, from young star economists.


People in developing countries are poor because wages are low, and wages are low because firms are very unproductive, and firms seem to be unproductive in large part because of bad management.


[We need to] identify the determinants of intergenerational mobility, with an eye towards finding policies that increase equality of opportunity. Should we be focusing on increasing access to higher education? Changing the structure of elementary schooling? Revamping thetax code?


[We will see] the study of traditional questions, such as how to use monetary and fiscal policy to eliminate unemployment and control inflation.


The modeling of agents with bounded rationality will help us build economic models (in particular, macroeconomic and financial models) and institutions that better take into account the limitations of human reason.


In an increasingly globalized world, the search for answers will necessarily require a much deeper understanding of three areas that interest me. One, we need a better understanding of the interlinkages across countries in trade, finance, and macroeconomic policy.

I stopped, but it continues in this way. If BigThink asked me, I would say:

I see a big payback to integrating psychology, anthropology, and history into economics more directly, using real-world data to understand how prices, output, and inequality relate to institutions, norms, education, and taxes. And vice versa.

Of course I’m being a bit snide because I find these answers as vapid and trite as any politician’s platitudes.

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Mayor Of Bankrupt California City Explains Where She Failed

Ann Johnston

Charles’ Murray’s Losing Ground was that most incentives in life are negative, in that if you don’t do X you will starve or freeze or whatever. Thus, you learn to be thrifty, nice, and hard working to simply get by.

The most common complaint by businesses as to why they fail is that their  banker stopped lending or seized their collateral; if they just had more time things would have turned around.

Promising large pensions is one of those things that keeps increasing future liabilities, and if you simply plan based on cash flow–including borrowing–you will hit your constraint with probability=1. Bankruptcy seems to be the only realistic constraint.

 Here’s a now bankrupt city mayor explaining a minor lacunae in her management style:

Stockton Mayor Ann Johnston voted for these expensive measures when she served on the city council. ‘We didn’t have projections into the future what the costs might be…I learned that you don’t make decisions without looking into the future’… ‘Nobody gave thought to how it was eventually going to be paid for,’ says Mr. Deis, the city manager.

Who knew?

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Keynes Had A Ridiculous Vision Of The Future


I really dislike fawning Keynesians because I used to be one when I was a TA for Hyman Minsky back in college (he was a Post-Keynesian). As such I was amored with Keynes, and read many biographies about him. There’s no greater ire than that of early infatuations, in part because we feel tricked, and these objects remind us of a naive earlier self that wasted part of our precious finite life on a wrong road. Anyway, I can’t can read the familiar Keynesian tropes (eg, ‘Keynes wanted to save capitalism’) without rolling my eyes.

A good indicator of a failed vision is a fanciful endgame.  If that endgame is clearly wrong the vision is wrong.  Marxists and their ilk thought the rate of profit would continually fall, until the proletariate took over and the state withered away.  In the 1940′s economists thought that while capitalism offered greater liberty, the higher productivity of socialism would overtake capitalism.  And then there’s Keynes’ famous 1930 essay The Economic Possibilities of our Grandchildren, in which he imagined that in 100 years or so, the greatest problem would be how to spend our leisure.  Note that Frank Knight, Ludwig von Mises, and Freiderich Hayek never considered this possibility, highlighting their more accurate understanding of human nature.

Anyway, the latest Keynesian thumbsucker to take on this essay is biographer Robert Skidelski and son:

The irony, however, is that now that we have at last achieved abundance, the habits bred into us by capitalism have left us incapable of enjoying it properly. The Devil, it seems, has claimed his reward… The point to keep in mind is that we know, prior to anything scientists or statisticians can tell us, that the unending pursuit of wealth is madness. The first defect is moral. The banking crisis has shown yet again that the present system relies on motives of greed and acquisitiveness, which are morally repugnant.

This pompous blowhard grew up part of Britain’s upper class (he’s a Baron, whatever that means), and watching one’s status fall stings.  Now he wishes money, and the market skill generally associated with it, weren’t so important for determining one’s social status anymore (though it was fine when gramps made the family fortune that bought his peerage).

 He asserts that because Westerners got rich because we are intrinsically greedy, we now are rich but do not enjoy it because we are greedy: a Faustian bargain indeed! Yet, looking at hunter gatherers or hippies, both anti-materialists, I hardly see a more cultured, meaningful, or higher levels of existence.  Mark Zuckerberg, meanwhile, seems centered, nice, intelligent, and interesting.

 As per greed being repugnant, I don’t see what is intrinsically wrong with greed if such people are not hurting me. Minding my business under the rubric of safety or fairness, in contrast, is a much more common sort of intrusion in my life, and extremely unwelcome. Greedy people who pay for themselves by creating things of great value to others are both more fun and virtuous than do-gooders who spend all day thinking about new ways to force other people to work for other people.  Of course, there’s a lot of luck and skulduggery involved in any market economy too, but it’s more fair than anything else I’ve seen.

Skidelski assumes that we should be egalitarians, and so, anyone wealthier than me hurts me via my now lower relative wealth, regardless of what he does with the wealth. That’s not society’s problem, that’s his problem.

He imagines the standard Marxian utopia of people engaged in thoughtful, productive, artistic activities, and notes we don’t seem geared that way right now:

The pleasures of urban populations have become mainly passive: seeing cinemas, watching football matches, listening to the radio, and so on. This results from the fact that their active energies are fully taken up with work; if they had more leisure, they would again enjoy pleasures in which they took an active part.

So, he advocates we all become artisans of some sort, making homebrew, tending gardens, writing poetry.  Yet he notes people like to relax by just watching a movie.  If they didn’t have a job, would they then more actively partake in their leisure?  I doubt it.  As Henry Ford said, I can think of nothing less pleasurable than a life devoted to pleasure.

People get most of their pleasure, and meaning, being useful to others, which includes inspiring the admiration or happiness of others by one’s actions. Every time I make my daughter squeal with delight makes me thankful to be alive, because I know she really loves me, and I work to provide her with things and habits that will make her prosper, and hope that at some point after I’m gone she will remember me with sincere gratitude. A healthy wage is a strong correlate with one’s usefulness to non-family members, especially if you work in field without a lot of regulation.

Our valuations are not just internal, which is why in Robert Nozick’s famous experience machine thought experiment where one is asked if they could spend their life in some sort of holodeck that offered incredible but fake experiences,  most people don’t want the fantasy life. This is because living in a morphine high of solipsistic pleasure isn’t estimable, but rather, pathetic. A satisfying life affects other people in a positive way, which is why those ‘flow’ advocates really don’t understand what they are talking about–it’s not the flow, its the feeling that one’s focused actions are banking esteem in some communal credit bank, even if it is in some future world.   It’s paradoxical that those focused on mandating altruism seem to think satisfaction can and should come purely from within.   

In contrast to the Keynesian vision of us all trying to figure out how to spend our endless vacation, there’s Eric Hoffer, the enigmatic philosopher who appeared out of nowhere around 1934 in California at age 34, and claimed to be an autodidact longshoreman. I suspect he was a German immigrant who at one point was a rabbinical student, and wanted to avoid immigration restrictions so he made up some story about growing up in Brooklyn.  

Tom Bethell’s recent biography of Hoffer notes   his vision of the future was prescient, not fanciful, highlighting a much greater profundity.  Hoffer himself didn’t take much to make him happy: a well-written book to read, and evidence someone thought well of him.  He thought intellectuals found free societies a threat because such societies didn’t need mandarins directing them, and if not flattered would help incite the masses to some sort of revolution.  A man is likely to mind his own business when it is worth minding, and so those unhappy with their own meaningless affairs will focus on minding other people’s business. Hoffer noted one must not merely provide for those without meaning in their lives, but provide against them, because in a democracy and market economy their preferences will have power. Those who see their lives as inferior and wasted crave equality and fraternity more than they do freedom, and this can cause a Republic to fall to a democracy, and ultimately a tyranny.

In other words, Hoffer describes the essence of the Liberal desire to micromanage society into perfect equality at the expense of liberty. We haven’t figured out a good outlet for these do-gooders, or a good way for those without a purpose to find life rewarding, so they continue to plague us with their plans and angst. That’s a realistic vision of society, a future problem that is real yet potentially soluble.

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It Stinks To Be A Volatility Buyer

The VXX and TVIX target the VIX futures index, a metric of forward-looking volatility, and trade well over 40 million shares a day. As the VIX went up from 20 to 80 in 2008, which I guess makes a lot of people think this is a smart trade. With all the tumult this year, the VIX has remained about the same since the beginning of the year, but the VXX and TVIX are down 41% and 72%, respectively.

Since inception (Jan 2009), the VXX is down about 95%, and since Jan 2008, the SPVXSTR index (which matches the VXX pretty well) is down about 88%, so it’s not like over time this strategy has a positive return.

I bet a large fraction of these buyers have a copy of The Black Swan on their bookshelf.  The best way to play the volatility game is not to buy it, but to avoid relatively high volatility assets.  People overpay for stuff with large positive skew, like lotteries, and volatility.


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Why Stock Market Volatility And Bad News Go Hand In Hand

If you look at implied volatility, or actual volatility, it goes up when markets decline, and falls when markets increase.  The reigning best explanation is that since most companies have some amount of debt, bad news increases leverage as the firm values fall, and higher leveraged firms have higher equity volatility, ceteris paribus.  While this ‘Merton model’ explanation explains a little of what’s going one, it probably doesn’t explain that much in practice.  I mean, it’s not as if a Merton model helps predict equity volatility, even though KMV likes to convince its clients this is one of their valuable special tactics in predicting firm distress (don’t believe them).

John Geanakoplos has been interested in leverage and business cycles (I noted his lecture below). Along the way he noted that there isn’t really  good theory for the stylized fact that volatility tends to go up when markets go down.  Why should volatility be contemporaneously correlated with market declines rather than market climbs?

His theory is as follows: because people lever up more on assets that have higher bad news/high volatility correlations, because such assets don’t fall much after the bad news, because so there is still a lot of uncertainty to resolve.  Investors prefer such assets with negative news/volatility correlations because they can lever them more.

Now, this argument is tenable only under the cover of a complex setup using real analysis, so that the simple argument being made seems like Godel’s incompleteness theorem.  Yet, the answer is simply baked into his assumption of how various assets generate payoffs, and so has this faux-endogeneity that economists love.  You see, endogenous results come out of the math (supposedly), there’s no assuming the result, whereas ‘exogenous results’ are simply assumptions.  Of course, these models have their exogeneity hidden in the rigged set up (note his asset payoff trees), which is as convoluted and artificial as any mathematical treatise on spherical horses moving through a vacuum.

Myself, I prefer the simpler theory.  When times are good you simply do more of what you did yesterday, because that was good and you want more of it.  There is little uncertainty in doing more.  When things are bad–eg, you are losing money, or can’t borrow any more–then you need to do something different, you can’t afford to do what you did yesterday.  As they say, things always end badly, otherwise they wouldn’t end. There is a lot of uncertainty in doing things different, because there are now a bazillion things that you could do. Thus, bad news brings more uncertainty because it implies change, and good news bring lower uncertainty because it implies repetition.

Now, that won’t make it to JET (the most rigorous of the esteemed economic journals) like Geanakoplos’s paper, but it’s truly a better theory. 


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Why You Shouldn’t Take Any Advice From This Week’s Big Hedge Fund Conference

Ira Sohn

I wasn’t really aware of the Ira Sohn Conference, but some very big names were there. As Richard Posner pointed out, however, intellectual reputation invariably lags achievement, so the biggest names almost by definition are over the hill. A great example of this was Ronald Coase, who remarked upon winning the Nobel Prize in 1991, “it is a strange experience to be praised in my eighties for work I did in my twenties.”

 In any case, last year’s recommendations generated an average return of -8%, but the year prior was up 22%.  Thus, net over two years they returned a little less than the S&P500 over that period, adding yet another datapoint to the observation that advisers slightly lag the passive indices. On the bright side, Jim Chanos had two home-run picks–shorting VWS and FSLR–which will probably be sufficient to generate hope that while on average these recommendations are no good, if you pick the right ones, you can make a fortune. 

Such is the perennial problem with advice, in that on average it is unhelpful at best. Like education in general, trying to obtain wisdom given everything people have done and written is not straightforward. Surely reading such information is essential because no one could come up with all those insights by themselves, but unfiltered such data is no more informative than pop culture.  A lot of people with good intuition actually start ignoring such advice rather early because they see the diminishing marginal returns, why humans clearly become wiser from 0 to 30 then pretty much level off on average.  I suspect it’s like Sturgeon’s law (ie, 90% of everything is crap), in that those who like to take a lot of advice or read a lot includes some who are very wise and who have learned much from the past and others; but most highly educated people are don’t understand that they aren’t necessarily becoming wiser because they choose the bad gurus, or build upon bad assumptions.

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The ‘Anti-Taleb’ Is Showing The Path Toward Low-Volatility Investing

Pim van Vliet

Last week I was at a conference sponsored by one of the world’s leading low volatility fund managers, Robeco, over in Rotterdam. Low volatility investing was really pioneered there by Pim van Vliet, who was influenced by papers by Bob Haugen among others in graduate school (eg, Commonality of Stock Returns, 1996 JFE).

That is, Pim believes, as I do, that higher risk generates lower-than-average returns, and this creates a great investing opportunity because obviously you can get lower risk and higher return by investing on risk; there is a dominant strategy implied by the empirical data if you believe in the normative implications of modern finance. This intuition guided him in building one of the world’s first institutional low volatility focused investment strategies. They have about $2.2B euros allocated to low volatility investing.

Now, Pim is an anti-Taleb. That is, Nassim Taleb suggests that most economists are unaware of uncertainty, fat tails, overconfidence, or that theory is different than reality, all paradigm changers. That these insights all have long academic threads is important to acknowledge, however, because it implies their lack of obvious application is due to something important that would be useful to know. For example, fat tails do not alter any of the main insights from the gaussian assumption when calibrating risk premiums, everything works in the same way, just a little more or less. Thus, they can usually be ignored, because they are isomorphic to assuming people have greater risk aversion, or that gaussian volatility is higher than its measured volatility by some fraction. Suggesting this phenomenon is the key to why mistakes were made is very misleading, and leads to inefficient or wasteful correctives.

 In contrast, van Vliet is eager to highlight he is not saying something that is new so much as important and true. In Haugen’s case, his writings did a nice job of demonstrating raw volatility being inversely correlated with returns, which is nice because all you need is for the relation to be flat for low volatility investing to be superior. Subsequent to his discovering this phenomenon, he found my work, and thinks it’s fabulous that I am championing this idea, and so invites me to speak on this subject to his clients. I guess he’s trying to convince people that if other people found this independently, it’s really there. A pioneer, but not a singular one.

 By acknowledging others so vigorously he’s showing a lot of intellectual modesty, but not so much that he does not think he is right and the conventional wisdom is wrong on something very important. Thus, he has managed a portfolio that combines the singular low volatility focus with complimentary factors such as quality and momentum, innovations that are straightforward, but it’s hard to riff on a theme unless you have confidence that comes from knowing you aren’t hiding anything from others or yourself. It isn’t obvious how and when to combine good things, as any good chef knows, and they have something better than your simple SPLV ETF. A good example is how Huij, van Vliet , de Groot, and Zhou (2012) discuss how distress risk can compliment volatility metrics, as they are really different manifestations of the same thing.

 Now, Bob Haugen’s presentation there was very lively, and he stated he gave 60 talks on low volatility last year, mostly overseas.  I can see why because he is very provocative and not dry. One of his points was that he discovered low volatility anomaly back in a 1975 paper that even Haugen did not remark upon for several decades. If you read this papers you see that he indeed did say that higher risk did not generate a return premium, but his explanation centered on ‘market inefficiency.’ What does it mean that markets are inefficient? Well, all that means is that markets are predictable in at least one but perhaps several ways, and so it encourages one to adopt any of those dopey get rich quick strategies that crowd the investments section at the bookstore. Just as Haugen went on to highlight a variety of predictable patterns unrelated to volatility over the next 35 years, most readers of these papers would not take-away the idea that low volatility investing is superior to the indices.

 I would say Haugen discovered low volatility investing in the same way Vikings discovered America. He found it before most, but he didn’t know what it meant when he found it, and only with hindsight figured out it directly underlies something very valuable (ie, low volatility investing).

 There’s about $12 Trillion in the US equity market, and currently about $10-$20B worldwide is directed at low volatility. The discovery of low volatility investing as an attractive idea is a better Sharpe ratio improvement than the move from active to index funds because you can reduce volatility by a third and increase the returns by a couple percent, so I think this trend will have legs, and low volatility will grow 10 to 100 fold over the next ten years.

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