under the macroscope

Why is no one digging into why the bailout is so necessary _right_ now?   The problems are not new, what exactly is new?

Simplifying the events pre-crisis, the ECB just told the Cypriot banks that the credit line is closed.   When the illiquid assets on the books of the Cyprus banks (Greek bonds and such) are worth much less than the depositor base + equity, we have a hole that needs filling.   We can be generous and assume that this hole is somewhat smaller than the $17B claimed to be needed (in reality, its probably bigger and much much bigger if you try to value assets--GGB bonds--during a fire-sale).   And once the ECB does not allow the bank to use the ELA to swap these illiquid and optimistically-marked "assets" for liquid cash to support the daily operations, the bank is essentially insolvent.  In other words, if the depositors came asking for their money, the bank cannot satisfy the needs -- not immediately (which is the case with any bank) but also NEVER (as the assets are worth less than the liabilities).  Now, if State of Cyprus cant make the deposits whole on one insolvent bank, which it has guaranteed, it, too, is essentially insolvent and the insurance guarantee it has provided the rest of the banking sector is worthless.  Depositor is every Cypriot will start asking questions about just what is backing the "short-term loan" he or she has made to the bank at low interest rate and whether its worth getting the risk.  As deposits fall, the hole gets bigger, the sovereign is increasingly unable to make good on its promise and the classic vicious cycle of a bank run starts.  And worse, if one Euro sovereign can default, who else is next?  That is why depositor guarantees are there in the first place in a fractional banking system.  To ensure that people believe the risk is minimal and allow the bank to arbitrage liquidity of money by selling long-term money (loans) at higher rates and buying short-term money (deposits) at lower rates and "managing" the duration mismatch.  If you strip away the guarantee, the short-term loan looks a lot riskier, liquidations of long-term assets in fire-sales is painful and creates a self-fulfilling prophesy.   That is why creating any doubt that the guarantee is not "good as gold" is a terrible terrible policy decision to take.  If and when some of these banks reopen, will its depositor base still be at $68B or whatever it was before this crisis?   And if they arent, what is the size of the gap between true value of assets and deposits?  Is it still going to be that $17B figure?   I would venture that gap is much much much bigger and just like in the Lehman crisis, in a uncertain, unresolved crisis, get much worse by the day. The ECB can still continue to support the banks and provide liquidity pretending that the assets are worth book.  But then, that is just German taxpayers paying.  And that may still happen.  To a point.  As we've seen in nearly every recent European election, the propensity of voters to suffer meekly and support politicians who want to continue the charade is getting weaker and weaker.

One would have hoped that there was some lull in the Herbalife saga with the recent company conference.  But no such luck.  Perhaps with the same hook as reality TV, it continues to draw attention in a stage full of debt limits, Euro gyrations and Japanese monetary politics.  Recently, a manager and blogger I respect, John Hempton posted his "Notes on visiting an Herbalife nutrition club in Queens".  WSJ MarketBeat picked up the story headlining one of Hempton's claims as 'the most easily falsified bear-thesis I have seen' and I got sucked in.

Ackman may very well be wrong, but it’s clear that he's done his homework.  And given the timeframes, he has had more time to do so than those who are more reactionary (Loeb, Hempton and the rest of the late-to-the-party players incl. myself). I'd venture that his research is more thorough than even Ann Coughlin's who was given company access.  But hard work and correct answers are not always correlated (as a few of my old college grades can attest).

John Hempton’s post confuses many issues together.  The three issues of interest are:

Is Herbalife a _illegal_ MLM scheme?

Is Herbalife a good buy for investors?

Does Herbalife have some value for society -- at least in the sense that any productive company does?

Clearly, the answer to #1 is the realm of FTC lawyers and perhaps the SEC has some stake in consumer protection (of investors).  I am not a lawyer, but to my novice eyes it appears that the definition of an illegal scheme revolves around whether the revenues accruing to the company and to the "uplines" are more the result of sales or recruiting.  Herbalife, I suspect intentionally, has tried to confuse the two. Its proposal to split out the consumption-only distributors will help greatly in making his assessment.  It remains to be seen, though, how many become "special customers" to get a discount on a product that is no cheaper (and perhaps quite a bit more expensive) than a competing product, if no business opportunity dream comes attached?  What is the price of a hug?  

Ackman details his case on the fraud – I am not an expert here to judge but at least he has made a case. It doesn’t matter to regulators what social good a company does, if by the letter of the law, it runs an illegal MLM scheme. Lance Armstrong can hardly claim back his medals, regardless of however good of a person he is or what good he does for society if he broke the rules in winning his medals. The problem is not solved by merely calling negative P&L businesses “customers”.  And on this point, I found the evidence in Hempton’s blog fairly light.

#2, on a fundamental level, is Herbalife a good buy?  With Herbalife, we have come to a binary outcome because expectations of growth rates are clumped at two opposite ends. Its historical growth rates, buy-back strategy, cash-flows etc. are all irrelevant at this stage.  If it turns out, either through regulatory action or via bad publicity, its "distributors" just don't buy and more importantly recruit others, the game is over. Herbalife’ s core business is about selling “hope” – the management knows this and even the founder knew this and it will last only as long as people believe and more importantly, regulators cooperate. But if, in fact, this is actually a tempest in a tea-pot (as has been in the case in the past accusations), and Herbalife can continue to put up the numbers and discover untapped markets, it is a screaming buy. It boils down to sustainability.

Even if turns out that Herbalife is exploiting under-informed masses but doing so without running afoul of FTC laws, it says little about its future prospect.  And hedge fund managers, of all people, know that “exploiting information asymmetries” is quite legal and very profitable.  The only question relevant here is whether the down-line will continue expanding and whether Herbalife can keep reaching into new markets for that “pop”.  It may eventually run out, but “hope” is a very deep well and HLF may very well enrich investors for a long time.

But, whatever the answer about fundamentals, there is still the money that can be made from the technicals. This is a stock that is grabbing headlines, TV-screens and webpages, distracting as they may be when much bigger issues are at stake. The stock is hard-to-borrow. And float and short interest are both concentrated with a few players. Big swings will be the norm. An emotional retail base is mostly playing with leverage -- options, esp. on the short side (borrow, time structure of vol, IV all point to this).  As this past Monday must have demonstrated to many ITM put holders, you can be right on the direction and go very wrong on technical flows come option expiration. But there is a lot of money to be made predicting technical flows correctly. I would wager that Loeb and Hempton are more in the latter camp than the former.  I'm not sure that Loeb believes that HLF is a  stock to be put away for children and grandchildren or even a "pick of the year", as much as he believes that Herbalife can survive long enough for him to be able to put a massive squeeze on the shorts.

The third question is interesting but rather peripheral to most professional investors.  Whatever your ethical opinions, when you play with other people’s money, you are beholden not to your personal ethical feelings but to a fiduciary responsibility.  Here is where I objected most to Hempton's post.  One, John knows very well that Herbalife is not AA. AA does not charge people an entry fee for the social support it provides. It does not pitch one product and sell another.  You cannot blame Ackman for being out-of-touch with low-income distributors in one breath, and with the other believe it’s no big deal for Herbalife to peddle its products for a $50-$100 (real money to low-income distributors) "entry-fee" alongside a story of Ferraris and mansions that these “business owners” have no chance of realistically achieving.  Clearly, Herbalife products are not low-cost leaders. Herbalife itself doesn’t claim they are "cheap" even if they sell them primarily to a population that is normally very price-sensitive. So, it smacks of a noblesse oblige mindset to imply that it’s okay to overcharge or dupe unsuspecting parties in order to do them some good because they don’t know what’s good for them or are able to make best decisions on how to spend that money. If it is indeed exploitative, Herbalife can no more redeem itself socially on the “community service” and "hugs" card than Madoff could have by building hospitals and schools with his ill-gotten wealth.  Herbalife has a much bigger obligation to play it fair and transparent with its distributors than it does to solve their health or social issues.

On the other hand, I find Ackman’s implicit or explicit claims about being a hero to the downtrodden equally superficial and self-serving. His fiduciary responsibility is to his investors and all the bravado would be for naught if he does indeed turn out to be right but loses money on the trade. He has no more of a right to spend his clients' money on social betterment than Herbalife does to try to improve its customers' health via deception.

There appears to be a fascinating game of poker between big-stake players and sadly, as often is the case with great games, with real lives and livelihoods at stake. While I understand Ackman's motivation in publicity once he made his bet, I do not understand opening the kimono so wide. Why reveal the form of the bet (no options)?  I can even understand declaring that he will not cover – in essence making it a “Thunderdome” trade with only one winner.  But why reveal your hand and size of your bet, other than to play hero to the CNBC crowds?  With respect to legitimacy, he only needs to answer to the SEC. I even find rumors of Herbalife’s high-powered lawsuit far-fetched (the last thing Herbalife wants and the thing that Ackman actually wants is a bright light on Herbalife’s business model).  I may be too poor a poker player to not know an ace up his sleeve (some SPV with borrow locked-up), but I fear that is more bravado and bluff and it will be hard for Ackman to withstand a big squeeze.  The Feb earnings will start revealing the endgame and I, for one, can’t wait to get on with the next episode of “must-watch market-TV”.

Market choice: Picking the right ocean to sail

In my first post: Why bother investing?, I laid out a case for using liability-matching as an overarching goal.  But I also pointed out its limited usability as a day-to-day rulebook for investing. Future liabilities are often unknown, hard to estimate and often require special domain knowledge to hedge properly. So why bother with the whole exercise?  Why not just invest and aim for the best return possible?

Because starting our investing odyssey is hardly possible if we don’t determine the market we will invest in. If you are working towards saving for your kids’ education, where costs are rising at 7-10% per year and your financial plan requires a 15% compounded growth rate, it would hardly matter that you outperformed the S&P but came up short on your goal.  If it’s critical to your plans that you invest your funds to make a down-payment on a house, it’ll be foolish to tie that need  to how Apple performs in your portfolio (beyond any correlation Apple equity may have to your actual liability). If you are a retiree on fixed income, will your pension’s bond fund investment outperformance against other bond funds give you comfort if it doesn’t beat the inflation for your basket of goods?

So, even if money is ultimately fungible, it is our liabilities that determine our investment requirements and those liabilities should drive the choice of the market to invest in.  This is true even for professional investors, though the influence of investor liabilities’ on their market choice is very indirect. That doesn’t mean that the broader market isn’t a good proxy for our liabilities nor does it mean that we must invest only in a narrow niche.  Nor should anyone claim that we should not make forecasts in tangential markets or not make relative value call. Because, ultimately, truly uncorrelated market don’t exist.  But the overwhelming point is that having a good idea about your liabilities is critical to making sound investing decisions, understanding your tolerance or risk and formulating an expectation of return.

Of Hawks and Doves: Active and Passive Investing Whatever market we do choose, there is a basic question we need to answer first: Is this market efficient?  By definition, efficient markets are unbiased and do not afford active managers—even if very skilled—the alpha generation opportunity to justify their fees.  Passive indexing is a superior strategy in efficient markets. On the other hand, in inefficient markets, asset price don’t move entirely randomly. It implies that there are parties in the market that are, for one reason or another, making bets with a negative expected value and hence there is a potential for a skilled investor to generate above-market returns,  even on a net (of fees and taxes) basis.

Academics and fund managers have wrestled over this question of efficiency, even earning a few Nobel prizes over the years.  With basic analysis, we can see that it is exceedingly rare for managers to outperform the broad market over long periods.  While these numbers are often self-reported and notoriously difficult to estimate, David Kostin, Goldman Sachs’ chief economist, recently wrote in a note that 88% of hedge funds underperformed the S&P.  Yet, we also see evidence in certain strategies and with certain managers of outperformance (for e.g. many now-famous funds betting on the credit crisis, convertible traders in 90s and in 2009 and some people may even include investment luminaries like Warren Buffet) that cannot be ascribed to just dumb luck.  So how do we reconcile these facts?

The spice of life is that few answers to complex questions are absolute and even fewer are static.  Tweaking a classic game theory problem, let us pretend that active managers are aggressive, alpha-hunters of the investing prairie. They earn rich rewards when they encounter inefficient markets with big herds of passive investors. However, they also come with big costs, with expensive staff, higher transaction costs and risks and starve easily. Passive investors are dove-like.  They don’t reach out for outsized rewards nor do they take outsized risks and conserve capital on the bet, rather than pay it in fees.  In this scenario, is it better to be a dove or a hawk? 

Students of game theory will quickly point out that it depends on the additional rewards: size of the market and the level of “alpha” available after accounting for the higher cost and the probability of successful harvesting of it) as well as the relative proportion of the hawk and dove populations.  Where those variables constantly change, there is no stable answer. But even if the point of stability is in a state of constant flux, in our particular example with reasonable assumptions about costs and rewards, it should be intuitively clear that the biggest determinant of whether it pays to be a hawk or dove is the proportion of hawks to doves compared to the size of the market.  In crowded markets where there are a lot of alpha hunters who set prices at the margins, you can free-ride on the effort of their hard work in keeping the market efficient.  However, the more free-riders who blindly trust that prices are fair, the more likely it is that there are exploitable inefficiencies. Depending on the various markets we are invested in, it’s very likely that our choice to be a beta-rider or an alpha-harvester may change over time and by investing in different markets, we may have both active and passive investments in our portfolio.

But this answer begs the question: how do we determine if a market is efficient? One could do an analysis of the market return against the median of returns of actively managed funds. But after from the fact that this analysis is made much harder as biases in self-reporting, the longer periodicity in reporting (monthly or quarterly) with some funds, irregularity and even lack of reporting to external data-collectors, the biggest problem is that this may help us understand whether the market is efficient in retrospect.  It says nothing about helping us predict the efficiency of the market in future – which is what concerns us the most. With due respect to both the chicken and the egg, it may also be true that we can only define the efficiency of a market in retrospect.

But are there heuristics that allow us to guess at the efficiency?  

How big if the size of the market compared to the cumulative size of active manager strategies in that market?  There is less room for improvement, the more inefficiency hunters there are.

How similar are the strategies of the active managers?  Too many managers deploying the exact same strategy may actually make the market inefficient by introducing biases.

How open is the market? Complex strategies may require specialized domain knowledge, certain markets may be restricted to certain investors or may otherwise have barriers or policies that ontinue to keep inefficiencies in place.  However, this is a tricky point as unregulated markets often create opportunities for self-dealing and keep the market inefficient.

What are the liquidity characteristics of assets in the market?  Liquid assets that get traded (and hence market-priced) frequently tend to be make the market more efficient. 

What are the asset-flows in the market like?  Generally, large alpha generation opportunities draw capital and managers that exploit inefficiencies and make the market efficient over time.  

Conclusion

When we make a broad passive investment in the market, we’re spreading our bets across many assets.  What often gets labeled as a virtue – diversification – is simply the right strategy when we have no overriding conviction that one asset is better than the other.  It is simply another way to say that the market is efficient across those assets.  Very littlesignificant additional work is required if our aim is to simply deploy the capital allocated to that market in an appropriate tax-efficient instrument (generally an ETF).

An Investing Odyssey

“How do you invest in this market?” I often hear this rhetorical question from fund managers, usually accompanied with a shade of resignation, relief, disgust or despair depending, of course, on that day’s or month’s performance. Friends and acquaintances, who don’t invest as a career, ask a similarly unanswerable question: ‘What do you think I should invest in?’ To tackle a tough problem with a new perspective, I’ve learnt to break it down to its core. It’s clear that without clarifying our investing goals, it’s only a half-question and our answers will be superficial at best and completely wrong at worst. So before we answer how to invest, let us ask: why do we even bother investing?

From academics to doomsayers, we hear talk about the financialization of the world. In relation to growth of financial services, we often hear how countries are on the wane because they don’t make anything or make anything real, implying that financial economy is an illusion. But if so, why do we spend so much of our collective time, energy and resources on financial matters? Why does it capture TV screens and internet bandwidth?  Why do presidents, senators and congressmen hold press conferences and craft policy based on whether the market zigs or zags? Whether right or wrong, the numbers say that a large portion of our productive capacity is being allocated to financial matters. So, what is the importance of investing?

Original Debt

We are, all of us, original debtors. We start our lives as helpless babies, depending on someone else to feed us, clothe us and take care of us. We may choose to couch it in emotional terms and it may be hard to value, but it certainly can be priced and we most certainly start with a negative balance on our productivity account. The total cost of raising a child is estimated to average between $200,000 and $500,000 per child from birth till 18 years of age in the US. We grow up draining the resources of a society, and hope to grow old, likely once again consuming more resources than we produce at that stage. But the saving grace is that we also can turn these investments and those of our care-takers into productive lives, and create a lot more net “stuff” in our highly productive middle years than we consume at either end.  

Polonius was dead wrong. We are forced to be lenders and borrowers – from ourselves and from each other. Not only do we have little choice in the matter (and I haven’t seen independent income-earning productive babies being born somewhere) but as a society, as a civilization and as human beings, we function only and we function better because collectively we can maximize our potential through this process of borrowing and lending.  

But this is no free ride. Borrowing MUST match lending. This is an accounting identity. And lenders will only lend sustainably if borrowers generate enough savings to cover the liabilities of these loans. No one in this world is rich enough to issue a truly unlimited credit-line.

In this politically charged environment of fiscal cliffs and sovereign downgrades, it is important to state this again: We can borrow from others, we can borrow from the future, but over the long term, a society will continue to function only if we produce at least as much as we consume during our finite lifespan. Our politicians and cultural norms can dictate how we redistribute the costs and rewards. We can decide whether we waste resources or build savings, whether we over-consume or fuel growth via R&D, and even whether we can temporarily force our neighbors or our grandchildren to pay for our liabilities. But the mathematical reality remains that over time these two sides of our society’s balance sheet must match.

Raison d’etre:  Asset-Liability Matching

We are thus forced to invest because we are stuck with a classic asset-liability matching problem. We must gather assets or save to fund the periods when we will experience net outflows. Hence saving and investing is simply the bridge that allows us to match our assets with our liabilities. As individuals or societies, we must invest these excess savings in order to avoid the risk of not meeting our future obligations.  In a way, it is the only sensible goal that we can sustainably have for our investments in a closed system.

Investments take many forms. Some are intended to grow your assets, while others reduce your liabilities. Many of them can be implicit. These asset-liability matching games are played, consciously or subconsciously, on many levels and multiple times every day.  For example:

Families in less developed or agrarian societies often choose to “invest” by having many children, maximizing their labor assets to grow their productive capacity and to meet their liabilities in old age.

US Employees often invest a portion of their pay via 401K plans to meet liabilities they will incur during retirement. Certain sectors lure employees by promising to meet their future liabilities in the form of pensions or medical benefits.

As per the latest figures, US tax-payers spend an aggregate of $800 billion on education.  Today, even a “moderately”-budgeted US college education costs between $21,500 and $42,200. Students, parents and governments make these investments because they hope it maximizes individual and collective productivity leading to higher compensation, lower poverty and unemployment and healthier, longer lives.

To create a moral, a more compassionate, or some cynics may say placated society, many nations invest in social program, which maximizes overall productivity and reduces the cost of social ills.

Many central banks recently have enacted expansionary policies and courted inflation and moral hazard risks, presumably to avoid the liabilities that come with the economic shock of a recession or a depression.

So the right answer to our original question is...

Invest in a way that meets your future liabilities.

This anti-climactic answer is vague and non-actionable enough to be almost useless. Take the example of meeting our future healthcare needs. It’s easy to see that many of these liabilities are uncertain or unknown. Even if known, they can be hard to estimate. Worse, we encounter path dependence. Even to get the opportunity to fulfill a particular liability, we must first meet every other liability along the way. Yet, even if it doesn’t provide a magical solution, when faced with uncertainty and volatility this answer serves as a very good compass for our financial and emotional well-being. 

Will your investment choices cover your liabilities?

Next...

Part 2:  Practical Guidelines for Investing