Of Condemned Houses and Asset Shortages

Don’t look now, but the SF Bay Area housing market is on fire. A few weeks ago, a burned out house in San Jose sold for $800k and made national headlines. Now my town Fremont is making the news with a CONDEMNED home that sold for $1.23M.

Condemned house sells for $1.2 million in Fremont

There are logical explanations such as high rents and low rates support such prices and/or the buyers of the two aforementioned properties can tear them down and build a new structure with instant equity. Of course, that equity relies on today’s rates and/or prevailing prices. I’ll make no predictions on the direction of prices, but I will say that the supply and demand of assets often influences prices a lot more than economic fundamentals. This goes for nearly all assets from real estate to equities to fixed-income to cryptocurrencies and so on. For my fellow Bay Area folks, do please try to ignore the various narratives and ex-post rationalizations for why our real estate prices are hyperbolic; we simply have an extreme imbalance of supply and demand resulting from years of underbuilding. This is what an asset shortage looks like. Yes, “asset shortage” typically refer to “safe haven” assets like Treasuries, but when you live in a region where South and East Asian immigrants are the marginal buyer, real estate in a decent school district fits the bill.


“Gun Control 3” by Icy And Sot, courtesy of amplifier.org

Like many Americans, I’ve been saddened and angered by the increasing number of mass shootings in our country. My wife and daughters even braved the rain and hit the streets to March For Our Lives a couple weekends ago. As the activism against assault weapons increases, so are calls to divest from assault weapon manufacturers and distributors. Thus, I believe now is as good a time as any to talk about “divestment.”

Definition: Divestment is the act of excluding a company, industry, or sector from an investment portfolio.

Reasons to Divest

  • Many (including myself) practice divestment as a way to align their portfolios with their values. Some investors would rather not receive any investment benefit from the sale of assault weapons (or cluster bombs, chemical weapons, and so on) and so choose not to own companies associated with these products.
  • There is also an argument that investing in risky or controversial businesses is risky because risks and/or controversy invites activism which can result in stricter regulations. Just ask tobacco companies or oil drillers.

However, investors should also understand what divestment will not do.

Reasons Not To Divest

  • Divestment reduces the supply of capital available to a company which increases its cost of capital. However, there are still plenty of investors willing to invest. So although divestment increases a firm’s cost of doing business, it also increases the returns to that firm’s investors. Cliff Asness of AQR recently summarized this concept in an aptly-titled piece: Virtue Is Its Own Reward: Or, One Mans Ceiling Is Another Man’s Floor.
  • Readers may point out that a higher cost of capital and weaker financials should result in weaker share prices and performance. Perhaps in theory, but I have not found the weight of empirical evidence compelling.¹
  • Divestment campaigns have not been shown to be effective historically, except to the extent that they are a means for social and/or political stigmatism. William MacAskill (a leader in the “effective altruism” movement) asks and answers the question: Does Divestment Work?
  • Not only is divestment unlikely to hurt a firm’s shareprice or investors, it is unlikely to benefit those who divest. Excluding a miniscule industry like firearms manufacturers will make no discernable difference to capitalization-weighted investor. Excluding larger industries or sectors may result in increased tracking error versus a benchmark, but is unlikely to make a material difference over a multi-decade timeframe as most sectors mean revert to the market over time.² I’ve found most arguments otherwise are timeframe dependant (ie. just changing the starting and ending dates results in different outcomes).
  • The upshot is that if divestment will not make a major difference to an investor’s portfolio, then investors can also capture market rate risk and returns without many (if any) tradeoffs.
  • Investors that own funds may find it expensive to divest if they have unrealized capital gains. Rather than divest and pay tax on the capital gains, it would arguably be more effective to donate an equivalent amount to an activism campaign.

Other Options
Divestment is one of many tools that investors can utilize to align their portfolio with their values and/or effect change. Other options include:

  • Underweighting or otherwise optimize their exposure to objectionable companies, industries, and sectors. Kind of a “divestment-lite” approach.
  • Maintaining exposure to an industry or sector, but only invest with the most responsible or “best in class” firms (perhaps those that are pivoting away from the objectionable business).
  • Maintaining ownership of shares in order to engage with management through voting proxies and/or bringing shareholder resolutions. Sometimes having a seat at the table is the most effective way to effect change.
  • Invest in companies that counteract the problem or solutions.

Divestment can be a great tool to align portfolios and it is something that I personally practice. Like anything else though, investors should consider their goals and objectives to ensure that divestment is the right approach for them.

²http://www.nepc.com/insights/fossil-fuel-divestment-considerations-for-institutional-portfolios & https://www.mayorsinnovation.org/images/uploads/pdf/FINAL_Revised_NorthStar-Cost_of_Divestment.pdf

Knowing and Doing

“Painting is easy when you don’t know how, but very difficult when you do.” -Edgar Degas

My daughter took a climbing class and now we go to gym regularly to climb. In the beginning, I’d yell up to her from the ground: “Good job!” “Grab that red hold!” “No, put your foot on THAT blue one!” “Just grab that hold to your left!” She was generally reticent to take logical routes, which I chalked up to her cautious personality and young age.

Then one day, I put a harness on and got on the wall. From the ground, my daughter yelled the same things at me: “Dad, just grab that one!” I thought, easy for you to say from down there! “Daddy, just reach up to that yellow one!” Again, I thought: Yes, technically, I could do that, but I’m not sure I can reach it, it feels uncomfortable, it feels risky, and so on.

Doing something is often harder than knowing how to do it. I believe recognizing this encourages understanding and humility, which in turn helps to distinguish between reasonable and unreasonable expectations, criticisms, and so forth. Some may think such an approach is simply a lowering of standards, but I see it as providing a more realistic view of reality which leads to a better estimation of possibilities, probabilities, and ultimately better decisions and outcomes. The implications for due diligence, allocating, and investing in general are too many to count.

“In theory, there is no difference between practice and theory. In practice, there is.” -Yogi Berra

Context, Details, and Mechanics Matter (Olympics Edition)

During the PyeongChang Olympic Games, my four year-old daughter and I were watching skeleton (like luge, but headfirst and a sport I didn’t even know existed, previously). The athletes take turns going one at a time on a track, similar to the luge and bobsled events. It is impossible for an amateur like me to tell whether someone is fast or slow, except for the on-screen stopwatch that compares the current run to the fastest time. In the midst of one run, I commented “She is so slow!”

My daughter asked, “Why does it look like she’s going really fast?”

“Well, you’re right, she is going really fast. Really, really fast. She’s just like the seventh-fastest in the world instead of the fastest in the world,” I replied.

It was a simple reminder that context matters and that consumers of financial media (or even this blog) should assign very little weight to what is said and written about a great many things.

A financial analog to the above skeleton story are people saying they want to invest in stocks because they heard bonds are risky or crytocurrencies because “fiat” currencies are not a reliable store of value. Obviously, I’m not against investing in stocks or cryptocurrencies or anything else, but the preceding statements are ridiculous. Otherwise reasonable people say these things because they did not understand the context of something or do not appreciate magnitude of risks being described.

As Nassim Nicholas Taleb writes in his newest book “Skin In The Game”:

Don’t tell me what you “think,” just tell me what’s in your portfolio.

Most investors would probably be well-served to adopt Taleb’s approach. Having listened to a zillion sales pitches and investor calls, I can confidently say that what people say and do can be very different.

Consider a portfolio manager (PM) who is bearish, which is typical of fixed-income PMs. The PM may hop on an investor call and share some doom-and-gloom economic data, opine about the ineptitude of fiscal and monetary policymakers, comment on market risks, and so on. Yet, all of the preceding is likely general in nature and may have nothing to do with the portfolio holdings, not to mention vehicles used to gain exposures or positioning/views within capital structures. Additionally, PMs tend to think and act probabilistically, so position sizes, correlations, and expected return scenarios matter too. Lastly, opinions can change on a dime and investors can act in a way that seems opposed to their beliefs.

As an example, someone can be both very bearish and still invest:

  • because they accept that they can be wrong, don’t believe that the market can be timed, or are averaging down.
  • less aggressively than maybe they otherwise would (the same reason banned-from-baseball Pete Rose cannot be excused for only betting on his own team).
  • with a different risk/reward profile by managing their risk exposures, greeks (in options-speak), and so on.

Oftentimes, I recognize and respect some particular risk, but will invest and expose a portfolio to it if returns more than compensate for the risk, favorable convexity can be obtained, or a number of other considerations. Risk is hard to understand without an idea of probability, possible scenarios and consequences.

All of this is to say that when listening to an opinion, investors better understand precisely what is being communicated and what is not being communicated. General prognostications and/or commentary on specific risks are meaningless without an understanding of context, positioning, as well as expected probabilities and payoffs.

Caveat lector.

Short Vol’s Impact On The Market and What’s To Come

There’s been a lot of focus on short vol strategies this week and many questions about how long it can continue. For those that are curious, below is a brief explainer on how short vol has contributed to the selloff.

In short, this episode is a textbook example of forced selling. It can be tough for investors to see markets and prices move so quickly and irrationally, but it also creates opportunity as forced selling means that price action disconnects from fundamentals.

  1. In this case, it was short vol positions that were crushed. Short positions started losing money because the VIX was ticking up. To limit losses, the shorts needed to go cover their short positions by buying VIX futures, which pushed those contracts and the underlying index even higher. This is called a short covering rally or a short squeeze. It is essentially buying that begets buying. Interestingly, in this case, the squeeze was in the VIX which moves inversely to the equity markets; thus, a rising VIX put downward pressure on the equity markets.
  2. A major method of shorting volatility was to short futures linked to a volatility index. Futures have embedded leverage because investors only need to post a fraction of the notional value as collateral. When the position starts losing money, brokers will make margin calls demanding more collateral. If the investor cannot post more collateral, they’ll have to close out their position or liquidate other portfolio assets. Thus, they either had to buy and push the VIX higher or sell other risk assets which pushed their prices lower. Either way, equity markets moved down.
  3. Once the troubled assets and players are identified, investors will begin pulling allocations. Exchanged-traded products, mutual funds, hedge funds, and so on will receive redemption requests. They will be forced to close out their short positions or liquidate other assets to meet redemptions. Again, this will further reinforce the price action.

Short covering, margin calls, and redemptions have exacerbated the recent market declines and they could continue. It is unclear how much exposure still needs to be unwound or what the leverage ratios are. Friday’s bounce may have been the bottom or there could be more pain to come this week. Investors should have a gameplan in place to take advantage of either scenario.

Reposted Thoughts on Short Vol Implosion

I inadvertently deleted my last post on 10 lessons we can learn from this latest round of exploding vol and the implosion of short vol strategies and products. With everything going on in markets right now, I have to focus on other things and let that post go. I still have the images, so I can give a brief recap of those at least!

  1. AVOID shorting volatile assets and NEVER EVER short something that can spike up exponentially. It doesn’t matter how smart you are because you don’t know the future. History is littered with smart people that blew themselves up by shorting imprudently.
  2. Looking at the below chart, it’s difficult for me to understand how anyone could short the VIX in January. You’re getting a low price on your short sale and it frequently explodes higher. 
  3. Unfortunately there’s a lot of perverse incentives and other bullshit in financial services. Sponsors and managers are incented to create products to generate management fees, brokers and custodians encourage trading to generate transaction fees, and it nobody cares if the products are beneficial or not. Some of them are dangerous. Below is the VelocityShares Daily Inverse VIX Short Term ETN (symbol: XIV). Went down 90+% overnight. Investors lost money, while the product sponsor, manager, and brokerages all made money and didn’t lose it when the thing crashed.
  4. It’s not just retail investors that make mistakes though. Recently, a bunch of Wells Fargo advisors were fined for not understanding the above types of funds and making misguided  recommendations to clients. Another team that manages a hedge fund and a public mutual fund (symbol LJMIX) made some serious errors causing their mutual fund investors to lose 80+%. This is a publicly-registered mutual fund with the word preservation in it’s name. Buyer beware indeed! Knowing what you own is much more important than knowing it’s history. The magnitude of adversity often trumps the probability of adversity.

This is not an “I told you so” post. The lesson is that investing is tough, so implement some risk management as guardrails and be discerning and skeptical. Retail and professional investors alike are susceptible to greed and complacency.

Have a great weekend and back up your blogs!

Dollar Street

The great team at GapMinder has created Dollar Street, which is a very cool way of looking at the mundane all around the world. The photos are organized and standardized, so you can see what various aspects of life look like at similar income levels around the world. Check it out:


Also, an entertaining TED Talk about the site:

Leclerc: Heavy Loads of Colorful Vegetables in Kolkata

Had repost this series of photos which lies at the intersection of my interest in markets, India, and travel photography. Check it out!

Heavy Loads of Colorful Vegetables in Kolkata!

Highlights from AQR’s interview with Ed Thorp

Below is a fascinating interview with Ed Thorp, who discovered/invented many of quantitative methods used to beat casinos and markets. Full interview can be found here (PDF).

A few of my favorite quotes (and, yes, my confirmation bias is in full effect, since my firm focuses on passive index investing for equities and active investing for fixed-income and private equity/debt/real estate):

On the challenges of finding true alpha in liquid markets:

For liquid asset classes like US bonds and stocks, for instance, this means that everybody who is active, or not indexing, are
collectively a big index fund, on average. That big actively-traded “index fund” is being managed, so it’s also paying costs. So, a couple of percent is being drained out of that pool, compared with the guys who are paying very low amounts for passive indexing. So, these active investors collectively have a couple percent disadvantage. So, all the institutions that are battling for an edge in those liquid asset classes aren’t going to get alpha collectively. They should just index those parts of the portfolio, in my opinion.

On the opportunities in illiquid and opaque markets:

Sullivan: Where do you see additional opportunities for institutional investors?
Thorp: What I see for institutional investors is access to the more illiquid asset classes like private equity. That’s something ordinary investors don’t get a shot at, and it requires active management because there’s a lot of work in evaluating and
hiring managers.

On the importance of approach, strategy, and risk-management, even when the odds are with you.

Brown: A recent paper by Haghani and Dewey (2016) indicated that students in finance often lack the basic quantitative skills to properly think about risk.
Thorp: Yes. The authors conducted a live experiment with college-aged students and young professionals at asset management firms who were knowledgeable about investing. The experiment went like this: each participant gets 30 minutes and $25 to start with. Each has a computer terminal and is informed that they will flip a computerized coin that comes up heads 60% of the time and tails 40% of the time. Then they can bet as much as they want on each coin flip. After 30 minutes, time stops and they get to keep their gains up to a certain dollar limit (otherwise the experimenters might go broke!). If they reach the limit sooner, then betting stops, because they’ve won as much as they can. The others go on betting. So, the question is, what betting policy should you follow? Many of the participants had no idea what to do. Quite a few of them went broke and a rather large portion of them didn’t make any money. Another rather large section made some money but not a lot. The average amount of winnings was around $70 for those not going broke. Aaron wrote a nice piece (2016) which analyzed all this in detail. Winnings should be something like $240 if they follow optimal policy.
Brown: Yes. Very high probability that they’d win about $240 if they used the Kelly method, which as you already know says to bet 20% of their bankroll each flip on heads, calculated as 2(.6)-1=20%. Basically, there seemed to be two types of bettors,
risk-takers who went broke and non-risk takers who bet small amounts like $1 each time, so average winnings of even those not going bankrupt were quite low.
Thorp: Every year in Las Vegas they have something called the Blackjack Ball, where about 50 of the best gamblers in the world gather. If you were to ask any of these professional blackjack players what to do, they would have said, well, I’ll just use the Kelly Criterion because it’s a close approximation to an optimal solution. So, the professional blackjack players would know the answer, but the finance people did not.

Full interview can be found here: https://www.aqr.com/-/media/files/papers/aqr-words-from-the-wise-ed-thorp.pdf


Housel: What Other Industries Teach Us About Investing

I was amped for the release of Blue Planet II today, but I think this was the best video release of the day.

My favorite thing about this talk is that Housel covers some of the most important investing issues without even talking about investing! Nobody is immune from the challenges and biases that Housel illustrates, so its a great watch for both professional and non-professional investors.