In the last week of 2022, Alpha Architect launched the BOXX etf. Depending on your needs, it is a promising alternative to T-bills – but the thing that’s so cool — BOXX is doing the same trades option traders do to manage their cash!

Background

In the summer of 2022, I watched an episode of Show Us Your Portfolio, where professional investors discuss how they personally invest. This episode featured Wes Gray the founder of Alpha Architect.

• Show Us Your Portfolio: Wes Gray (YouTube)

• How I Invest My Own Money: Robust to Chaos (blog post)

  After appearing on the show Wes actually wrote out an in-depth blog post explaining how and why he invests the way he does. Notice the thoughtful appreciation of his constraints and goals, then see how he matches them with a portfolio.

I’ve gotten to know Wes over the years and found his framework deeply resonant with my own thinking. I called him to discuss certain aspects of it in more detail.

While discussing the portfolio, he told me about the upcoming BOXX ETF knowing I’d geek out on the options bit. Not to mention that the ETF is sub-advised by former colleagues from my SIG days.

Now that the ETF has been on the market for 9 months and garnered a critical mass of assets (>$400mm AUM), I feel comfortable explaining how it works. Before I get to that let’s discuss the value proposition to investors.

Features

I’m going to pause here because I don’t want to rehash research that is already well-done. Nomadic Samuel wrote a great explainer of the ETF:

BOXX ETF: Review Of The Strategy Behind Alpha Architect 1-3 Month Box ETF (Picture Perfect Portfolios)

There’s a section of the explainer I want to zoom in on:

Well, the Moontower reader is gonna understand how this thing works in a moment. A “box” trade is covered on day 1 for option brokers and trading trainees.

In general:

• the cost to borrow money is going to be the SOFR rate + the clearing firm’s margin
• the interest received on cash balances is the T-bill rate – the clearing firm’s margin

SOFR rates are derived from overnight loans collateralized by Treasuries, therefore they trade very tight to t-bill rates. The bulk of the financing spread is simply the clearing firm’s margin.

If t-bill rates are 6% and the clearing firm’s margin is 50 bps per side, then the clearing firm is willing to lend to the trader at 6.5% and pay 5.5% on cash balances.

The key insight: Market makers cannot freely borrow and lend at a single risk-free rate as theory assumes

At any given time there is likely some market maker that is cash-heavy and earning say 5.5% while another is paying 6.5% to finance long share or option positions. The box market is a way for them to increase or decrease their cash balances! If you are long lots of option premium and paying 6.5%, you can sell a box spread which allows you to lay off premium in exchange for cash. You might sell that $10 box for $9.95 effectively borrowing cash knowing at expiration you will owe $10.

This is smart — you are refinancing your position from paying 6.5% to the clearing firm to borrowing from the options market for 6%!
The point is that there is no real voodoo here — boxes allow market makers to re-finance their positions with each other effectively cutting out the banks.

If the rate prevailing in boxes is typically higher than the t-bill rate that tells you that the options world is a net owner of shares/option premium because the box rate is clearing at a slightly higher rate than t-bills imply.

I have mentioned that so much of options trading is not fancy ideas but mundane business considerations. Like keeping your financing under control. Boxes and their siblings, reversal/conversions, have active liquid markets. There are brokers who deal in them all day. At a large enough options shop, there is a trader who deals in them all day. It’s analogous to the treasury department at a bank, charged with minimizing funding costs.

The BOXX ETF is a legitimate innovation allowing non-option investors to buy box spreads. This allows them to lend at box rates. To supply liquidity to the options market which is a net borrower.
Caveats

• Funding spreads aren’t necessarily 50 bps per side. It depends on the client’s riskiness and how big an account they are. When I had a small private backer the funding spread was multiples of the funding spread I had at SIG or the hedge fund. The wider your funding spreads, the more inclined you are to trade box spreads so you can tap into the market rate and cut out the clearing firm’s margin.
• Your counterparty in box trades is the exchange clearing house. These are very strong credits. You face that risk any time you trade options. Wes addresses that in his article.
• BOXX holds European-style options so there is no early exercise risk.
• BOXX is tax efficient. In fact, it can be more efficient than owning state-tax-exempt t-bills but this is something for you to work through with an advisor. It depends on your specific situation.
• In general, derivatives markets, governed by the invisible hand of intense arbitrage pressures embeds funding rate very close to Fed Funds (ie short term t-bills) rates. When you buy an SP500 futures contract you are getting leveraged exposure since you only need to post cash margin at a fraction of the full notional value. This inherently levered position means you are borrowing. However, it is the most cost-effective form of borrowing because the rate is inherited from arbitrage by the most well-capitalized traders who can afford to lock in risk-free profits with the smallest possible margins. The team at Return Stacked Portfolio Solutions wrote a simple explainer post reviewing the mechanics — The Cost of Leverage

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Extra for Option Masochists

It’s hard to overstate just how deeply tied funding concerns are to vol trading.

If my stock long rate is much higher than yours then calls will have a lower implied vol to me than to you. Likewise puts will look more expensive than you. If I had a long stock position I’d want to swap it for a long synthetic futures position by doing a “reversal” (buy call, sell put, sell stock). If my rate was much lower than the market I’d want to “convert” (sell call, buy put, buy stock).

See You Think You’re Trading Vol…But Are You Even?

Every option trader has used revcon.xls to price the exact carry on a position down to the T+1 settlements for options and T+2 for stock. They’d be counting days like fixed income traders.

Box spreads are the simplest arbitrage identities in the options market. They are the basis of figuring out what a put spread is worth by knowing the call spread value.

BOXX is a really neat product allowing equity investors to tap into the borrow/lend markets that were once fenced off to option participants. And the option participants are happy because an already deep market is getting deeper.

Suppose you go to a brick-and-mortar coin dealer in your town and buy some gold. How confident are you that it’s real?

Pretty confident, I’d guess. You should be. By having a shop with non-negligible overhead and in-person transactions the dealer is signalling trustworthiness. Plus some percentage of the customers are going to be paranoid doomers who will assay a sample for purity. If it’s fool’s gold, there’s a good chance they’ll raise hell on Nextdoor and the dishonest dealer will lose business.

In asset management, the valuable thing to be mined is alpha. Consistent outperformance for a given level of risk. A true edge. Mining for alpha is conceptually similar to mining for gold. For a given extraction price there’s a limited supply. Part of that extraction price includes a return hurdle — there must be a profit margin to make the effort worthwhile. This is why markets will never be fully efficient and are said to be efficiently inefficient. 

However, spotting fool’s gold in active management is definitely not straightforward. Track records are prone to survivorship bias — if you flip 10,000 coins and keep the ones that turn up heads, about 10 coins would remain after a decade. You still wouldn’t “hop on a call” with these coins. The problem is even more diabolical. The shrewdest investors are usually well-resourced. They are like a metallurgy expert who would have separated the real stuff from the fool’s gold before you get a look. And since there’s some probability that the alpha is fake, investment fees should clear at a level that discounts the probability that it’s fake. No star manager is selling their alpha in a 40-Act fund (this is a basic “market for lemons” argument).

This is a stylized equilibrium. There are exceptions but the burden of proof is on the promoter. Remember, alpha is zero sum — there must be losers for there to be winners and if you don’t have a good reason for why a winner wants your money then you’re tossing rings at a carnival. You’re gonna spend $50 to win a $5 panda that you’ll throw out in a week. Worse yet, you won’t throw the investment out, you’ll just keep paying for its upkeep while it sheds lint all over your portfolio.

Byrne Hobart, recounting some amusing research, states how reality differs from the equilibrium (emphasis mine):

Chengyu Bai and Shiwen Tian have a study showing that more attractive fund managers get promoted faster but have worse returns . A good model of asset management is that skilled managers gather assets until their fees roughly equal the alpha they generate. It’s not a stable equilibrium for someone to be able to get rich by passively moving money out of an index fund and into an active manager’s fund, and managers like having money. So, in general, skilled managers raise more money (or charge higher fees) until their after-fee returns approach what someone could get elsewhere. Unskilled or unlucky managers find a different line of work. But this model describes an asymptote, not the state at any point in time; even if it’s true, there will be some emerging managers who are putting up good returns but not getting enough credit for it, and others who either have a good pitch or a lucky year or two and can over-raise accordingly. (And, of course, some managers are not purely money-motivated, and keep their firm at a size that’s appropriate for whatever they like most, whether that’s turning over lots of rocks in nanocap stocks—a rewarding activity at the moment!—or funding private companies that are barely past the idea stage.) If there’s some factor that makes it easier to raise money (being good-looking can keep you out of jail for longer, so it makes sense that it would apply in other places), then those managers will raise more than they should. The good news for anyone who isn’t strikingly attractive but does want to make money in investing is this: alpha only exists if there’s someone worse than you on the other side of the trade, so beauty bias in fundraising means better returns for everyone else.

In the equilibrium version, managers with alpha choose their investors strategically for some synergistic benefit OR they charge fees that slide most of the alpha money to their side of the table. As Byrne says, that equilibrium is an asymptote that we never quite arrive at. Some managers are overearning while others are underrecognized and underearning compared to the value they create.

This is also why the general rule of long investor letters quoting Roman emperors are bad signs. True killers don’t ramble and only move at night. Of course, a star doesn’t just emerge a killer, he or she arrives there. So identifying one before they reach the height of their bargaining power can be a lucrative trip (if you can find them before the pods do)

I could just invoke the Yogi Berra “I don’t want to be part of any club that’ll have me” line and if readers internalized that they’d save themselves some fees as well as the inevitable “are these just sugar pills” moments of doubt.

But there’s always some overachiever who believes the wire that binds effort to outcome in a low-signal process is tighter than it is. Let me offer some thoughts.

Heuristics for Choosing An Active Manager

In the cheeky article Proprietary Trading: Truth and Fiction, notable quant Peter Muller drops an evergreen table:

As a basket, those managers penning flowery investor letters quoting Roman stoics would be nice candidates for the short leg of a strategy (there should be a borrow market for private LP stakes. That might even make Twitter fun again). When I look up the website for a firm and find a landing page from 1998, that’s exciting. Lowkey goated.

That said, animal spirits are a thing and junior killers might want to have their name on the door regardless of how much their employers offer them. When they go out on their own there’s a small chance you cross paths with them before they reach the height of their bargaining power.

Potential Drawbacks of Private Investments

Trust

Public markets benefit from transparency. Law, regulation, and customs contain recourse and precedent. Boards are accountable. Reputations matter. There are blemishes but considering how much money and risk are regularly trafficked in modern capital markets you would expect some error.

Private markets are caveat emptor. Trust is a matter of transparency and alignment which go hand-in-hand. Even with a rigorous diligence process professional allocators can find themselves bamboozled. Now move down the chain. If a syndicate is corralling small retail checks on the internet, it’s worth asking some questions that go beyond strategy and performance.

1. Am I a client or just a customer? How valuable is this relationship to the GP? An extreme example of this is the crypto staker — an anonymous source of capital in a murky market. Illegal immigrants are easy targets for scammers because what are they going to do? Call the cops? You can see the parallel.
2. What’s the extent of principal-agent problems or conflicts of interest? Does the GP own a brokerage firm as an outside business? Is your PE manager raising a fund to buy stakes in its other funds? Too obvious? What if PE funds raise money to buy stakes from other PE funds, but they all started doing this? When I was in the pits, floor brokers were allowed to trade for their own accounts but not against their own orders. So you know what happens? The brokers show the juiciest orders to other brokers first before showing the market-makers. And what do you think will happen when those other brokers get a juicy order? Again, you should see the parallel.
3. Why did they find me instead of raising institutional capital? The answer to this doesn’t need to be nefarious. Institutional capital is expensive to raise both from a box-checking/pedigree point of view and the nature of long sales cycles for large checks. They can also be demanding LPs whose rigid discipline might be meddlesome and misguided. (That said, the best institutional LPs, perhaps rare, can actually level up a manager by sharing practices they see in other funds and generally being insightful). But if the syndicate that found you just sees you as a cheap source of capital, you’d want to know that. If their primary skill is audience-building then the most tempting monetization path can be to raise a bunch of money and flip a coin. You don’t want your GP’s superpower to be gathering eyeballs when they’re supposed to be investing.
4. Here’s a wonky one. You are an investor in a fund that charges 2%. Would you rather they ran the strategy at 30% volatility or 15% volatility? The answer is you’d rather they run the strategy at the higher volatility and you allocate half as much. Your proposition is unchanged but you pay half as much in fees. The GP prefers you don’t understand this. There’s a similar misalignment for traders and portfolio managers who do not get a percentage of the total firm p/l but get paid on their individual p/l. Those traders are equivalent to LPs. They want maximum volatility and little diversification because their compensation is a call option. If the firm is diversified, the trader faces “netting risk” where they might make money but another part of the firm loses money. The GP collects their fee and there’s no net return to pay the winners. This is the “basket of options is worth more than an option on a basket” idea. In this example, the trader and the LP are in similar positions and neither is fully aligned with the GP.

I don’t mean to make you feel like private investments are spellbound by dark arts. These issues are usually not issues — until times get tough. But that’s when you care the most because of the next topic.

Liquidity

Private investments are less liquid. Lockups, redemption notice periods, possible gates. Depending on the strategy much of this is unavoidable. But illiquidity is brutal. It hamstrings your ability to rebalance and tax-loss harvest.

Behavioral arguments for tying up your money as forced savings or “protecting you from yourself” are overfit, ignorant of counterfactuals, and coincidentally convenient to the people who promote them. The cost of illiquidity is visible and confirmed by market prices (on-the-run vs off-the-run Treasuries). Liquid collateral literally earns you a lower cost of funding. If you want to get nerdy about it see How Much Extra Return Should You Demand For Illiquidity? where I offer at least a qualitative framework for how to value it as an option.

Entanglement

What if the private investment goes well? Is this the equivalent of beginner’s luck in blackjack? Did you learn anything or just gain confidence?

When performance slides it’s hard to foresee how the manager will respond. They are below the high watermark, is the morale low? Are employees quitting? Bad times will come. Are you going to stick through them or add more?

In Repetition Economics, I frame the problem in the context of another industry oozing with snake oil:

If you start taking vitamins, do you have a plan for determining if they are “working”? Or have you signed up for a perpetual liability with an unclear benefit?

Gary Basin explains this concept more broadly in Action Echoes:

Rather than seeing this temptation as a one-off event, view it as repeating over and over into the future. Imagine the decision you make this next time also deciding how you act in similar future situations. Your actions echo into the future. Every “bad” move has consequences later in the game. Sure, you can sometimes find ways to dig yourself out of a hole. But it’s helpful to realize that every move you make contributes to your eventual position.

Reframing a decision as a bundle of future repeated actions gives a more accurate view. The goal is not to entirely avoid urges but to reframe them in a way that best accounts for their consequences. Any single temptation is not unique! The actions you take now will establish patterns that determine your future.*

Private investments are partnerships with people. You are subscribing to some very difficult future decisions when you write that check. When we add up all these drawbacks, the reasons to step out into the world of privates need to be incredibly compelling. With all these Family Feud X’s buzzing your accredited investor dreams I suppose it’s only fair to discuss some of the benefits.

Benefits of Private Investment

True Differentiation

You are invested in a business; not stock pickers

This is the holy grail. You get access to a strategy that is nothing like beta. If it acts like beta but simply outperforms it’s hard to size up because of its correlation to the rest of your portfolio and probably your employment. But if you find something that poses as an investment but is actually a business oscillating between making steady money and occasionally tons of money then you found the thing worth blasting through all the orange cones for. It’s only a matter of time before the world catches on to your discovery, but if you take a chance on the team early, they will reward you by not pushing you out as they grow.

The approach here is looking for quirky stuff where the team is strong but for any number of reasons are unable to attract the attention of suits and have no interest in soliciting the masses.

Authentic diversification

There are assets that are overpriced on a line item basis but because they are uncorrelated with beta that can improve an overall portfolio (vol, commodities). You will tend to notice massive dispersion in the returns of the active managers in those classes. This means there’s space on the field for them to justify their fees by being skilled players and having relationship moats. [It also means there isn’t a benchmark that anyone cares to hug because the benchmark itself has a tenuous grip on anything relevant to mainstream investment thinking. Start explaining a managed future benchmark to an equity investor over drinks and they are definitely answering the staged bail-out call.]

Relationships

In How I Misapplied My Trader Mindset To Investing, I wrote:

I appreciate that people can find an edge in their respective domains. I was spoiled by trading. Expiration cycles, large sample size, and a lack of beta meant edge, positive or negative, reveal you faster. Investing is a more wicked domain. My default belief is still that edge is rare and mostly unavailable to me. Storytellers can hide in the randomness and low signal-to-noise. And I’m not fully immune from them anyway. Still, I believe if you filter well, the number of times you get burned will just be the cost of doing business. Any private investment has to satisfy my doubt as to why I should be invited. And once invited, I am mostly judging character and ability. This is admittedly an act of faith. I’m pattern-matching to successful traders I’ve seen. I’m comfortable betting on people. Not because I even know if I am good at this, but because I think there are more ways to fail forward. If I constrain my risks at the sizing level I can more easily enjoy the positivity that emerges from partnering, helping, and believing in one another. It’s more holistic than a spreadsheet.

In a recent interview with Meb Faber, Ted Seides articulated my wife and my feelings exactly:

Most of the [private] investments are actually people that I’ve known for a long time. I don’t have investments with the big brand-name people. Part of that, for me, is an angle on active management, and certainly, this style of active management that I think is completely lost in the active-passive debate, which is the relationship aspect of it. Because I can give money to a manager, and yes, I will get the returns that come from that, but who knows what else is going to happen, both potentially financially and also just in life, right? There’s so much optionality that comes from having great relationships with people. It’s one of the reasons why it was easy for me to have a bias towards sticking with managers. I can’t stand ending those relationships with people I respect and think are smart. And I’ll happily, like, take a little bit of a financial hit in the short term if I think it’ll keep going for the long term.

More helpful reading before you take the plunge

Byrne’s concept of equilibrium is powerful even if we believe that the marketplace is constantly trending towards, but never settling into that equilibrium. Efficiency is a fractal problem. It takes effort to find alpha, and it takes effort to find managers who find alpha.

At equilibrium, I contend that there is a Paradox of Provable Alpha:

If an external edge is provable, it doesn’t exist for you. either you won’t be admitted to the club or the price will negate the advantage.

The paradox casts an inescapable conclusion — you will need to rely on judgment more than track records to find managers.

The following are all outstanding reads to augment your judgment:

Letter to a friend who just made a lot of money (Graham Duncan)

This is one of the best things I’ve read on delegation. To allocate “decision space” use a qualitative formula:

credibility = proven competence + relationships + integrity

Excerpts

Identify what you’re good at and how you’re going to use that strength

Our founding client, the CEO of a large home builder, is fond of saying that it’s common for people to make money like professionals and then invest it like amateurs. Warren Buffett says that if you don’t know who the dumb money at the poker table is, you’re the dumb money. In order to avoid being the amateur or the dumb money, I would first try to establish what you and people who know you well believe you have a lot of credibility in doing.

Delegating “decision space”

General Stan McChrystal, who together with his chief of staff, Chris Fussell, led the U.S. military’s Joint Special Operations Command, observed that their job in running all of the special forces units in Afghanistan was to assess the various team captains’ credibility and then give them the appropriate amount of “decision space” based on that assessment. To allocate decision space they used a basic formula: credibility = proven competence plus relationships plus integrity.

I see the task of managing a pool of one family’s or foundation’s capital as essentially that same exercise — assess people’s credibility on a given activity, and then give them the appropriate amount of decision space based on that assessment.

What you need to do is assess your own credibility and that of potential partners, and then decide how to divide up the decision space over your capital. It’s important to take your own ego out of it and assess your own comparative advantage with clear eyes. Warren Buffett gave his entire savings to the Bill and Melinda Gates Foundation to manage his charitable giving; he had a quiet ego and saw that they could do it better than he could ever realistically do himself. Bill Gates owns a ton of Berkshire Hathaway because he knows that Buffett is much more credible on making investments than Gates will ever be himself.

The bottom line is that giving your team captains both autonomy and accountability is critical.

The no-man’s land, which we see people fall into all the time, is where the capital owner wants to have one foot on the playing field and one foot off, suggesting ideas to the manager of the capital without having to execute them. That puts the manager in a uniquely bad position: if they pursue the investment and it doesn’t work, they get the blame; if it does work, the owner gets the credit. Several prominent family offices have gone through way too many CIOs to count because of this dynamic; now no one credible will ever again take the job because they correctly realize that it’s a “tails you win, heads I lose” proposition.

Figure out how you’re going to build trust with your manager

Assessing credibility and building trust is a skill, and it’s learnable.

I have a question I ask candidates when I’m hiring them for a skill set I don’t have: “if you were going to hire someone to do this, what criteria would you use?” The answer is often wildly different for apparently similar people with similar backgrounds and reveals what they believe to be critical based on their experience.

When it comes to a CIO to manage your capital, I would answer that question with the following criteria:

A) Someone who can provide evidence that they have good “taste” in people; has an ability to assess other people’s credibility and give them the appropriate amount of decision space; and attracts the top talent by exuding an attitude of abundance about fees and opportunities, an implicit message of “let’s compound our capital together”

B) Someone with a “quiet” ego who is pragmatically focused on making money for you (and themselves, assuming they have incentive compensation), not on scoring style or status points or constantly proving to you how smart they are — as Taleb puts it, deep down they want to win, not win an argument

C) Someone who is conservative by nature; hates losing money with a passion but, paradoxically, can still take “good” risks; and has that unusual mix of aggression and paranoia

Believability In Practice (Cedric Chin)

Excerpt

The technique mostly works as a filter for actionable truths. It’s particularly handy if you want to get good at things like writing or marketing, org design or investing, hiring or sales — that is, things that you can do. It’s less useful for getting at other kinds of truth.

I started putting believability to practice around 2017, but I think I only really internalised it around 2018 or so. The concept has been remarkably useful over the past four years; I’ve used it as a way to get better advice from better-selected people, as well as to identify books that are more likely to help me acquire the skills I need. (Another way of saying this is that it allowed me to ignore advice and dismiss books, which is just as important when your goal is to get good at something in a hurry.)

I attribute much of my effectiveness to it.

I’m starting to realise, though, that some of the nuances in this technique are perhaps not obvious — I learnt this when I started sending my summary of believability to folks, who grokked the concept but then didn’t seem to apply it the way I thought they would. This essay is about some of these second-order implications when you’ve put the idea to practice for a longer period of time.

Looking for Easy Games — How Passive Investing Shapes Active Management (Mauboussin)

This paper, especially page 29, shows dispersions of return in various asset classes. This is a clue to where an active or private manager can justify their fees.