The Seppuku Portfolio

Markets have been chaotic

Extremely high realized volatility.

  • Weekly moves look more like annual moves. In other words, the market has been sqrt(52) or about 7x more volatile than in past years.

Whipsaw correlations

  • There have been days when bonds and stocks have simultaneously sold off significantly. Gold correlation is a random number generator.

Dislocations galore.

  • Some of these are ETFs and closed-end funds deviating from NAVs. This screener can show you closed-end dislocations. Be careful with this stuff.
  • Treasury basis trades
  • This week gold futures surged higher relative to spot prices amidst talk of delivery bottlenecks across the pond. Then Friday front month-second month gold futures spread collapsed $30.
  • Oil contango exploded wider this week with the front month now trading at a 15% discount to the second month. Annualize that. It’s not surprising that tanker pure plays surged higher (if you are interested in a deeper look, check out this Adventures in Capitalism post.). The contango widened similarly during the GFC as the arb was limited by supply of credit. This time it’s about the limited supply of storage/tankers.

The chaos reflects the uncertainty in the real economy

Unemployment claims this week was a 30 sigma event which says as much about using normal distributions on financial variables as it does about how acute this shock is to the economy.

Options trader turned restauranteur and entrepreneur extraordinaire Nick Kokonas linked to Vanity Fair’s:

“You Can’t Speak in Strong Enough Dystopian Words to Describe It”: Why the Coronavirus Pandemic Could Change Dining as We Know It, Forever

The combination of perishable inventory and high labor costs as a percentage of sales makes the restaurant biz especially vulnerable. Restaurants are one of the better examples of the types of businesses facing an existential threat. Businesses that are exposed for their outsize degree of operating leverage.

I recommend Howard Lindzon’s Panic with Friends YouTube interview with Rob Koyfin as they dive into that idea. Rob’s the founder of Koyfin which is what Yahoo Finance would be if Bloomberg owned it. That’s a joke by the way. I use Koyfin myself but really liked watching Rob navigate the platform on the call to demonstrate just how the market was reacting to high operating leverage businesses. It was a markets lesson and tech tutorial in under 30 minutes. (H/t to Brian for the rec)

Personal portfolios

I like reading how markets people invest personally. We have a professional subscription to Jared Dillian’s Daily Dirtnap and he posts his portfolio and what he’s doing. His letter is paid so I will not share his allocations.

2 of my favorite fintwitters are public about their own investments:

Corey Hoffstein (Link)
Meb Faber (Link)

Moontower Portfolio

If you are curious about the Moontower portfolio it’s roughly:

1/3 real estate
1/2 short term notes and cash
15% public investments
<5% private investments

A look at the public portion:

8% RE
39% international equity
14% domestic equity
20% metals
18% US energy

Recently doubled down on energy/metals tilt, rotating out of treasury notes.

I refer to the public portion as the Seppuku Portfolio since it would be suicidal for a US investment manager to hold.


A note on carrying so much cash compared to most recommended allocations. It is a risky long-term proposition. Just consider the price of stamps in the past 30 years. But in the near-term, it provides a lot of optionality.

It’s reasonable to argue we overpay for this. While we don’t own our own businesses, there is a lot of volatility in our professions. A lot of lumpiness in our cash flows. But just like financial options I believe there are additional multi-order greeks on this optionality. They don’t come from differential equations. They are psychological. A behavioral edge even though I sort of hate this term.

Let me rationalize, I mean, explain.

We put a lot of value on the ability to not work for an extended period if we chose to. Not because of laziness but for the feeling that choosing to work where you are is an active choice. When Yinh took 2018 off this felt like a stress-free harvesting of the optionality. She was able to search for the best possible match for a new job. I feel like the payoff from being able to find a match without pressure is a payoff that does not show up in your Mint view as a line-item. But it will one day show up disguised as a different balance sheet asset.

Our parents are immigrants. They came to the US in 70s with little. We learned everything about grinding from watching them. They still have little. They passed scarcity mindsets to us. And Kiyosaki likely thinks we are fools who learned our lessons from “Poor Dads”. But we did manage to learn about leverage and its many forms.

Our lack of financial leverage enables us to maximize our human capital leverage. With implied prospective returns uninviting for the past few years, this seemed like a reasonable trade. Our total allocation reflects that tilt. With that lens, I guess you can file this under market-timing. Call me a sinner.

If you can’t watch a bull market rage without you this is just as risky as being YOLO long. No easy answers when you think of multi-order effects of an allocation. You need to do what’s best for you. It starts with asking the right questions. And they mostly have nothing to do with finance.

Should You Invest In Stocks Now?

Should you invest in stocks now?

With the market down 30% from the peak, I’ve seen many variations of this question in recent weeks. Mostly people who dollar-cost average by adding money from every paycheck wondering if they should increase the amounts they put in since the market is “on sale”. It’s an understandable question — I load up on Lucky Charms when they go on sale.

Ok, number one, nobody is qualified to answer this question for you, so let’s get that out of the way. While I hope the following will help you come to your own answer, the learning opportunity here is to get a better understanding of how markets work.

We need to address the mistaken presumption in the question. There’s a bit of a myth that the market is cheaper today. Well, this is true if you compare current prices to past earnings. But markets look forward. Lower nominal prices do not mean bargain. If fundamental deterioration was steeper than the price decline the market is actually more expensive. What a buyer is really interested in is whether the prices are a better value. If Trader Joes sells bruised bananas for half price, the cheapness is for a reason. Right now corporate America’s prospects are brown and soft. Is 30% the right discount? It’s a coin toss.

The market from a bystander perspective is nothing more than the fair point spread. In other words, whenever you put money in you are basically investing at the fair price. I’ll preempt some pushback to that by saying this perspective is a bit scope dependent. There are people who make money in narrow niches of the market that can be mispriced. Dislocations and liquidity frictions can mean opportunities for those experts. Just like if you were an expert in your local real estate market (have great contractor and banker relationships, got the look from the broker you grew up with, some other form of private info), market turmoil could lead to some easy layups. But zoom the scope out until you are a tourist and you are back to tossing fair coins.

This is always the case when you put money in the market. The price balances the buyers’ and sellers’ consensus of the future. Right now all buyers and sellers are meeting at prices that assume earnings in the future will be worse than they expected back in January. If you bet on Bucs to win the Super Bowl this year and Tom Brady gets hurt, the price to bet on the Bucs will get cheaper. The lower price to buy them is probably an equivalent value to the higher non-injured Brady price. It just reflects bleaker fundamentals.

Let’s belabor the point from another angle. The silliness of statements like “I’m a buyer of the market if it goes down to 200” when it’s currently trading for 3000. The unsaid assumption baked into that statement is “all else equal”. Well duh, all else equal, when the market is trading for 3000 there’s a stack of bids from 2000 to 3000. The only way your 2000 bid becomes in play is if the world is different. A bid is an inherently conditional statement. I wish I could have bought my house for $200k. But if my neighbor’s house ever goes on sale for $200k, it’s more likely we’re about pestilence deep into Egypt’s 10 plagues than I’m getting the deal of a lifetime.

Evergreen advice

It’s widely understood that the average stock picker is no better than chance at figuring out what a value is. A full-time endeavor whose output is no better than chance. The conclusion is obvious. Trying to time or beat the market is a low-yielding object of attention. You cannot do this reliably or repeatedly. Not worth the brain damage to trying to decipher if the market is a value. You aren’t counting cards to overbet a stacked blackjack deck here.

Focus your energy on understanding your liquidity needs. Give that exercise its full due. Only you have visibility into your family’s income in a slowing economy. Make sure you have the cash you need to live. Nothing has changed about the fact that the market tempts you with a reward in exchange for volatility. If the risk is suitable, stick to your regular plan.

(Mandatory disclaimer…I’m not giving investment advice. I’m not qualified and have zero credentials.)

A word on market consensus right now

The debate rages on whether the market is oversold or has a lot further to fall. The market price collapses the expected value into a single number. There’s plenty of smart-sounding people with models and forecasts and opinions and degrees on both sides of that price. All of these ideas are swamped by the other market-based consensus: the volatility. The options market is pricing the 1-year standard deviation of the SP500 at 40%. This is about 2x the market’s typical confidence interval. Volatility is a more actionable input into your investment process because it directly feeds into the thing you should be thinking most about — your cash requirements for upcoming expenses. If that kind of volatility is intolerable given your upcoming liabilities (retirement, college, buying a house, and so on), then you are overexposed. Stock returns have always been an award with strings attached. Volatility is not just small print. It’s a double-edged feature. If it didn’t exist markets would not offer a reward.

A Recipe For Overpaying

On the Gestalt University podcast, Chris Schindler has an intuitive explanation for the CAPM-defying empirical result that says higher volatility assets actually exhibit lower forward returns. Very simply explained — a large dispersion of opinion leads to overpaying. He points to private markets where you cannot short a company. The most optimistic opinion of a company’s prospects will set the price.

Options markets don’t care about CAPM. They model geometric returns. Higher volatility explicitly maps to lower expected geometric returns. I’ve referred to this idea as a “volatility drain” before. But here’s another way to see this. If you hold the price of an asset constant and raise the volatility the median expected outcome is necessarily more negative. Why? Because a stock is bounded by zero, so increasing the volatility should seemingly make the expected value of the asset higher. But if the market thinks the stock price is worth the same despite the higher volatility, that implies the probability of the asset declining must be higher.

(In reality, markets are constantly voting on the price, the volatility, and the left and right skew which allows an inclined observer to impute a continuous distribution.)

Back to Schindler’s point, if you want to fetch a high price for an asset, you want its value to be highly uncertain. Then sell it in an un-shortable auction with many bidders.

Dinosaur Markets

This past Wednesday, a NYT oped wrote:

..But after watching the stock market plummet on Monday and governments struggling to get hold of the contagion, I’ve begun to smell doom.

A response to this quote on Twitter:

“Hilarious. He only needs reactions of others to react, not basic facts.”

What do you think of that Twitter response? Is the oped author guilty of herd thought?

Let’s take a detour first, I promise it will re-connect in the end.

What Are Markets

There are various ways humans self-organize. Home life is an autocracy. Parents wield absolute power. If the kids get to vote on what’s for dinner it’s because the elders signed off on a temporary puppet democracy. In broader civilization, there are networks and governments. Plutocracy, theocracy, monarchy, parliament, communism, fiefdoms, tribes, democracy. No matter which backdrop they must operate in, one of humanity’s most clever constructs was the marketplace.

Through trade and barter, markets focus a multiplicity of needs, desires, and trade-offs into prices. Prices allocate resources. High prices attract supply and ration demand. A consistent ability to shrewdly respond to prices either as a company, investor, or consumer leads to profit. The potential and motive to profit certify prices as honest signals.

The Dinosaur Question

Democracies are controlled by votes. All votes are equal. But, markets are not democracies. To understand the difference I’ll recount a lesson I was taught as a trader trainee 20 years ago.

It was explained:

If you poll the population, “Did humans walk the earth at the same time as dinosaurs?”, the responses come back split about 50/50. That’s democracy.

Now imagine there is a contract that trades openly on an exchange that is worth $100 if it is true that dinosaurs and humans co-existed and $0 if that is false. Even though the population is split, this contract is not going to trade for $50. It’s going to zero. Why? Because the small percentage of people and scientists who know the truth are going to see a profit from selling this contract even down to $1 since they know this proposition is false. And if the scientists don’t have enough money, they will be able to convince or get hired by people with more money to back this venture of selling this contract to zero.

That is the value of markets. You get correct answers. While a democratic poll may tell you what people believe or desire, it does not assign the proper truth value to the proposition. Now consider the implications of being correct. You make more money which gives you more resources to continue being more correct. The marginal price in markets is set by the market participants with the most money and as a group, they have the best-calibrated assessment of what fair value is. And these groups are in the minority of the total betting population. Markets are not a democracy. To dismiss prices is an impressive act of arrogance.

An Aside For Finance Folks

You may recognize traces of strong-form efficient market hypothesis in this view. It is fashionable to point to market failures and bias which can distort the truth value of prices in our economy. Markets are nested within laws that are nested within our democracy. There are many joints in the structure subject to friction or even corruption which dilute the purity of markets. But for a market to be efficient doesn’t mean its truth value is decreed by the all-knowing. The standard to be efficient is simply to what extent you can earn an excess risk-adjusted profit betting against it. Well, by that standard market prices have a sterling track record revealing most players to be nothing but tourists. It could be wrong, but that doesn’t mean you can do better.

When Prices Seem Irrational

The correct reaction to strange prices is not to say “that’s stupid”. It’s “why is somebody paying that?” Prices are amazing discovery tools to explore “why”. When Vancouver condos are trading at egregious multiples over local wages, rather than presume the buyers were suckers, you may have discovered that Chinese nationals were restricted in how much Yuan they could expatriate. Real estate is a convenient store of value, not just shelter. While it’s not as stable as a savings account, the price of real estate as a safe haven for cash is not being set at the margin by someone like you. It’s set by a family across the world who finds its local savings account a bit too close to its government’s paws. The extra volatility is seen as nothing more than a convenience fee.

Ok, back to the tweet:

“Hilarious. He only needs reactions of others to react, not basic facts.”
Record scratch. Stop right there, freethinker.

When AAPL releases earnings, you don’t read the 10Q unless that’s your job. You look at the price after-hours to see how the market understood it. When a star player is placed on an injury report you look at the game line to see if the odds changed. These are correct reflexes for good reasons.

When you hear people lament that market prices in response to COVID-19 are being set by traders who know nothing about virology instead of doctors, pause for a moment. Are the sharps who set betting lines doctors capable of handicapping recovery times of turf toe or patellar tendons? Of course not. Their expertise is in looking at past data, pattern-matching, and propagating newly calibrated parameters through proven models to generate bets. A sharp’s long-term track record is a self-evident testimonial.

The best investors are information-synthesizing odds setters. This is being done across decentralized domains. The option guys are betting on volatility surfaces, the macro gals are thinking about growth rates and international money flows, while the fundamental folks are thinking about how many people are going to be watching Netflix, buying Purell, and working remote. VCs are Slacking their biotech founders while reporting back to their investors on calls. Those same investors close the loop back to the hedge fund managers who look up from their own war room analysis. The emergent consensus from all this hive activity is in fact what finance is. A networked machine optimized for pricing future states of the world. This optimization likely includes being networked to medical intelligence through its fastest pathways. The fact that it’s not all medical professional pathways should not offend. Instead, it speaks to how efficient this architecture is.

They say when you write to imagine who you are writing to. I feel like I just wrote to that person who has a market take based on what his rheumatologist uncle told him about viral infections. I’ll take my chances that the smartest people setting prices have access to the smartest minds in epidemiology.

The topic of market efficiency, the validity of prediction markets, and the wisdom of crowds would take several scholarly lifetimes to sift through. Who has time for that? I’ll just give you the tl;dr based on my professional experience.

  • Markets are very smart. If you cannot make sense of what they are doing most of the time you are missing something. I could fill a blooper reel of me getting served this lesson.
  • In the cases when you seemed to outsmart the market you are not actually on solid ground. You have probably just found seen an oasis in an epistemological desert.
  • Give prices their due. Understand your basis for mistrusting them when you do and see if you can test the supports for that basis with data as it emerges.
  • Finally, do not feel bad when you defer to liquid prices for an opinion. You will likely be in the smartest company.


If you are interested in the study of when to diverge from consensus, then muster some courage to read Inadequate Equilibria: Where and How Civilizations Get Stuck by Eliezer Yudkowsky. I plan to write a summary blog post of it one day but in the meantime read it for free online (Link).

I don’t follow the news much but keeping up on COVID-19 is one of those times. I subscribed to Taylor Pearson’s Twitter list which includes many smart voices ranging from scientists to investors. (Link)

For a single great follow on COVID-19, check out Balaji Srinivasan. He has been very on point in synthesizing the intelligence he’s gathered from various nodes in the system. He’s trying to steer a multi-disciplinary response to the virus (Link).

COVID-19 and Markets

I’ve explained in a past letter how the expensive put skew embedded in SPX option prices reflects 2 realities. First, the average stock in the index will see its volatility increase but more critically the cross-correlation of the basket will increase. Since index option variance is average stock variance times correlation, there is a multiplicative effect of increasing either parameter. The extra rocket fuel comes from the parameters themselves being positively correlated to each other.

In other words, correlation increasing leads to volatility increasing. Since volatility is a practical restraint on position sizing you can think of investment exposures as secretly levered to low correlations. Any battle-tested risk manager will pay close attention to not just net exposures of a hedged book but the gross exposures. The absolute size of the longs and shorts regardless of how offsetting they appear to be. Those gross exposures jump out of the closet to scare you at the worst times. When correlations rip higher.

Check out this bit from Byrne Hobart’s letter this week. First on correlation:

It’s a commonplace observation in finance that when markets go down, all correlations go to one. This makes perfect sense from a Minskian perspective: investors feel safe levering up when they expect economic fundamentals to stay healthy, but the more they lever up, the more any one fundamental change can break the entire system. But it’s also a broader truth: “Black Swans”—extreme events that blow up the assumption of a normal distribution—really only happen if a lot of seemingly-unrelated things are serially correlated. The reason models of the 2016 election underrated Trump was that they underrated the chance that the polling error could go in the same direction in every swing state. The reason credit default swaps on real estate-backed structured products were cheap in 2006 was that most investors didn’t realize that cheap credit had raised the correlation between housing markets, and that asset selection raised the correlation further within each structured product.

Correlation. A cute number between -1 and 1 upon which numbers with many more zeros rest. This can feel abstract if Excel is not your first professional language. When trying to adjust the current virus crisis to compare with historical ones, it’s useful to search for hidden forms of leverage including non-financial types.

Hobart continues:

The outcome of this is that every technology entrepreneur and investor needs to care about the global economy. The trends you’re counting on—free flow of capital, goods, information, and people—are dependent on a set of conditions that might not hold. And they’re correlated. Most useful macro discussions revolve around China, since it’s the axis around which the world economy revolves. But it’s also the lynchpin of the global electronics supply chain. Any plan that presupposes continuous improvements in smartphones and continually cheaper components assumes that China keeps on growing at the same pace, and remains tightly-coupled to the US, Europe, and emerging markets.

Manufacturers are realizing, and consumers are about to realize, that supply chains offer their own sort of leverage, with their own potential for a “Minksy Moment” in which a disruption in one place causes cascading chaos everywhere else. Coronavirus might be a minor speedbump, but it, or something like it, will eventually force a wholesale change in the pace and nature of globalization.

This week concerns of economic slowdown and supply chains as single points of failure are gripping markets. Wall Street is getting way in front of this one, calling for zero economic growth in 2020. Do we just jump to visions of empty planes and restaurants? Morgan Housel likes to remind investors of Napoleon’s definition of military genius: “The man who can do the average thing when everyone else around him is losing his mind.”

From Headlines To Numbers

Slow down to break it down. Consider what variables are being pushed around. Have a model. If your model maps variables to outputs then start turning the knobs to see how sensitive the outcomes are to different scenarios. The point here is not to do numeric Mad-Libs then believe the silly story you wrote. It’s an exercise in thinking. A model turns emotional headlines into dispassionate inputs so you can actually reason about them probabilistically.

My favorite analysis in this vein comes from the philosopher-king of valuation Professor Aswath Damodaran. He starts with his general model then shows at which nodes COVID-19 developments have an impact.

Again the actual numbers aren’t the point. It’s the calming process of seeing how abstract arguments which threaten to shut our minds down into fight-or-flight mode can be safely downshifted into cold digits. Type into cells, hit F9, generate an opinion that can just change with the facts. The full article including Damodaran’s spreadsheet. (Link)

I don’t have a strong corporate finance background. Damodaran’s website is one of the best resources on the web for learning. You can take his NYU course online or just go through his prolific writing. Tying together how growth rates, discount factors, reinvestment, and payout ratios all interconnect before arriving at valuation is actually fun to understand. I found it demystifying to work through this spreadsheet and I recommend it to anyone trying to understand the basics of how to think about share values. (Link)

If you want to see how he adjusts to new facts step through this post from Q42018 (Link)

Do Professional Investors Understand Fees?

Fees Are In Focus


Giant fund manager/brokerages like Vanguard and Fidelity have made fees front and center. Like Walmart, if you are the lowest cost provider and wield blue whale scale, you are going to compete on price. Competition has spurred a race to the bottom on fees. With many investment choices commoditized, the focus on fees has served customers well. 

If I wanted to nit-pick, I might say investors don’t fully account for more opaque fees when choosing funds. These can swamp the management fees. Turnover, slippage costs, borrowing costs and abysmal sweep account rates all have significant impacts on net performance. These hidden costs are not easily reduced to a number that can be compared to a management fee. Hint: it’s a good place to search for how managers are able to drive fees to zero. But that’s a digression. I’m not especially interested in retail. Their financial advisors are doing a good job using steak and wine to box out the fund managers. There’s only so much fee to go around.


Allocators have a more difficult job. They devote teams to parsing alternative investments. A sea of private investments and complex hedge fund strategies. Within that context the allocators must construct portfolios that trade-off between tolerable risks and the probability of meeting their mandates. 

The allocators rummage through a diverse mix of strategies each with their own mandates. Growth, wealth preservation, defensive, hedged alpha. A fund can be thought of as a payoff profile with an associated risk profile. A thoughtful allocator is crafting a portfolio like a builder. They want to know how the pieces interlock so the final product is useful and can withstand the eventual earthquake. 

A builder cannot think of materials without considering cost. Wood might make for a better floor than vinyl but at what price would you accept the inferior material? When builders estimate their costs they must consider not only the materials, but transportation costs and how the cost of labor may vary with the time required to install the material. 

So let’s go back to the allocators. If the menu they were choosing from wasn’t complicated enough, they must also evaluate the costs. This is a daunting topic. They face all the opaque costs the retail investors face. But since they are often investing in niche or custom strategies that are not necessarily under a public spotlight they have additional concerns. A basic due diligence process would review:

  • Which costs are allocated to the GPs vs the LPs
  • Liquidity schedules
  • Fund bylaws
  • Specific clauses like “most-favored-nations”
  • Netting risks1

Unlike their retail counterparts, the professional investor’s day job is devoted to more than just investments but terms. Like our builder, this cannot be done faithfully without understanding the costs. Mutual funds sport fixed fees but complex investments often have incentive fees (a fee that is charged as a percentage of performance, sometimes with a hurdle) making them harder to evaluate. Regretfully, I suspect a meaningful segment of pros do not have a strong grasp on how fees affect their investments. 

Understanding Fees

While it is challenging to price many of the features embedded in funds’ offering documents, there is little excuse for not understanding fees whether they are fixed or performance-based.  After all, if you are an investor this is one of the most basic levers that affect your net performance and does not rely on having skills. It’s a classic high impact, easy to achieve objective. It’s the best box in that prioritization matrix that floats around consulting circles. 

Let’s take a quick test. 

You have a choice to invest in 2 funds that have identical strategies.

They have the same Sharpe ratio of .5

There are 2 differences between the funds. The fee structure and volatility.

  Fund A Fund B
Expected Return 5% 15%
Annual Volatility 10% 30%
Annual Fee 1% 2%

Let’s assume the excess volatility is simply a result of leverage and that the leverage is free.

Which fund do you choose?

Normalizing Fees By Volatility

The correct way to think about this is to adjust the fee for volatility.

  • Fund A’s fee is 10% of its volatility (1% / 10%).
  • Fund B’s fee is 6.7% of it volatility (2% / 30%)

If you doubt that Fund B is cheaper from this reasoning you could simply sell Fund A and buy 1/3 as much of Fund B.

Let’s use real numbers. Suppose to had a $300,000 investment in Fund A. You would be paying 1% or $3,000 in fees. 

Instead, invest $100,000 in fund B. Your expected annual return and volatility would remain the same, but you would only pay 2% of $100k in fees or $2,000. Same risk/reward for 2/3rd the price. Compound that.

I am not alone in this observation. From his book Leveraged Returns, Rob Carver echoes that a fund’s fees can only be discussed in context with its volatility:

I calculate all costs in risk-adjusted terms: as an annual proportion of target risk. For target risk of 15%/year and costs of 1.5%/year, your risk-adjusted costs are 1.5%/15% = 0.10. “This is how much of your gross Sharpe ratio will get eaten up by costs.


A Clue That Some Allocators Get This Wrong

Allocators will often target lower vol products for the same fee when a higher vol fund would do. To be fee-efficient they should prefer that managers ran their strategies at a prudent maximum volatility. Optimally some point before they were overlevered or introduced possible path problems. There are many funds and CTAs that would just as easily target higher volatility for the same fee. Investors would be better off for 2 reasons:

  • Allocators could reduce their allocations

As we saw in the Fund B example, it is more fee-efficient for vol targeting to be done at the allocation level not the fund level.

  • Limit cash drag.

They would stop paying excess fees for a fund that had been forced to maintain large cash reserves since it was targeting a sub-optimal volatility. Why would an allocator be ok with paying fees for funds that are holding excessive t-bills?

If you are not convinced that investors’ preference for lower vol versions of strategies demonstrates a lack of fee numeracy then check out this podcast with allocator Chris Schindler.  As an investor at the highly sophisticated Ontario Teachers Pension he witnessed firsthand the folly of his contemporaries’ thinking around fees. While mingling at conferences he would hear other investors bragging that they never pay fees above a certain threshold.

As we saw from our example, these brags are self-skewers, revealing how poorly these managers understood the relationships between fees and volatility. Not surprisingly, these very same managers would be invested in bond funds and paying optically low nominal fees. Sadly, once normalized for volatility, these fees proved to be punitively high. 

This brings us to our next section. How would you like to pay for low volatility or defensive investments?

Tests to Compare Fixed Fee Funds with Incentive Fee Funds

A Low Volatility Example

Let’s choose between 2 identical funds which only vary by the fee structure.

Both funds expect to return 5% and have a 5% volatility. Yes, a Sharpe ratio of 1.

  • Fund A charges a fixed .75%
  • Fund B charges 10% of performance from when you invest. Fund B has a high watermark that crystallizes 2 annually.

Which fund do you choose?

A Large Cap Equity Example

This time let’s choose between funds that have SPX-like features

Both funds expect to return 7% and have a 16% volatility.

  • Fund A again charges a fixed .75%
  • Fund B again charges 10% of performance from when you invest. Fund B has a high watermark that crystallizes < annually.

Which fund do you choose?

Studying The Impact Of Fee Structure

I wrote simulations to study the impact of fees on the test examples.

The universal setup:

  • Each fund holds the exact same reference portfolio
  • 10 years simulation using monthly returns
  • Random monthly returns drawn from normal distribution 
  • 1000 trials
  • Fixed Fee Fund charges .75% per year deducted quarterly
  • Incentive Fee Fund charges 10% of profits crystallized annually

Case 1: Low-volatility 

Simulation parameters:

  • Monthly mean return of .42% (5% annual)
  • Monthly standard deviation of 1.44% (5% annually)3

This chart plots the outperformance of the fixed fee return vs incentive fee return fund annually vs the return of the portfolio which they both own. The relative performance of the 2 funds is due to fees alone. 


  • It takes a return of about 7% or higher for the fixed fee fund to outperform.
  • This makes sense. A 75 bp fee is difficult to overcome for a 5% vol asset.
  • If the asset returns 5% the performance fee would only be 50bps and we can see how the difference in fees approximates the underperformance of the fixed fee fund for 5% level of returns.

Case 2: Large Cap Equity Example

The universal setup remains the same. 

We modify the simulation parameters:

  • Monthly mean return of .58% (7% annual)
  • Monthly standard deviation of 4.62% (16% annually)


  • Most of the time the fixed fee fund outperforms. So long as the return is north of about 4% this is true.
  • The most the fixed fee fund can underperform is by the amount of the fixed fee. Consider the case in which both portfolios lose value every year. The incentive fee fund will never charge a fee, while you will get hit by the 75bps charge in the fixed fee fund. You can see these cases in the negative points on the left of the chart where the portfolio realizes an annual CAGR of -5%.
  • Conversely, the incentive fee can be very expensive since it captures a percentage of the upside. In cases where the underlying portfolio enjoys +20% CAGRs, the simple fixed fee fund is outperforming by about 150 bps per year. 

Bonus Case: The High Volatility Fund

Finally I will show the output for a low Sharpe, high volatility fund.

The universal setup remains the same. 

We modify the simulation parameters:

  • Monthly mean return of .42% (5% annual)
  • Monthly standard deviation of 10.10% (35% annually)


  • This case demonstrates how complicated the interactions of fees and volatility are. The fixed fee fund will massively outperform by even as much as 200bps per year when the portfolio compounds at 20% annually.
  • The fixed fee fund even outperforms at low to mid single-digit returns albeit modestly. 
  • The high volatility nature of the strategy means lots of negative simulations, thanks to geometric compounding (for further explanation I discuss it here). When a fund performs poorly you pay less incentive fees so it’s not surprising that in many of these case the fixed fee fund underperforms by nearly the entire amount of the management fee. 


Fixed Fees

  • Best when the volatility of the strategy is high and the returns are strong (again you are warned: most high volatility strategies don’t have strong returns because of geometric compounding).
  • The most a fixed fee investor can underperform an incentive fee investor is by the amount of the fixed fee.

Incentive Fees

  • Best when the strategy is low volatility or returns are negative. Or the asset is defensive in nature. For hedges or insurance like funds, you may prefer to pay a performance fee to minimize bleed.
  • The amount an incentive fee investor can underperform is technically unbounded since it’s a straight percent of profits.


  • Fee structures must be considered relative to the volatility and goals of the strategy. There are no absolutes. 
  • By dividing fixed fees by the fund’s volatility you can normalize and therefore compare fund fees on an apples-to-apples basis. Even seemingly low fixed fees can be very expensive when charged on low volatility funds. 
  • Incentive fees look like long options to the manager (which implies the investor is short this option). The investor has unbounded potential to underperform a fixed fee solution and can only outperform by the amount of the fixed fee (the left hand side of those charts). To further study the embedded optionality of incentive fees see Citigroup’s presentation.
  • Incentive fees are meant to align investors and management. Who can argue with “eat what you kill”? But they can also create bad incentives. If trapped below the high watermark, the manager has nothing to lose and may swing for the fences irresponsibly. In addition, a staff working at a fund that is underwater might be dusting off their resumes instead of focusing on getting back on track knowing that they need to work through uncompensated p/l before they see another bonus. 
  • Fixed fees can encourage management to diversify or hold more cash to lower the fund volatility. These maneuvers can be combined with heavy marketing in a strategy more colloquially known as “asset-gathering”.


Fees need to be considered in light of the strategy. This requires being thoughtful to understand the levers. Unless you are comparing 2 SP500 index funds, it’s rarely as simple as comparing the headline fees. If we all agree that fees are not only critical components of long-term performance, while being one of the few things an allocator can control, then misunderstanding them is just negligent. A one size fee doesn’t fit all  alternative investments so a one size rule for judging fees cannot also make sense. Compared to the difficulty of sourcing investments and crafting portfolios getting smart about fees is low-hanging fruit. 

Nobody Is Bigger Than The Market

2 brief things this week.

1)  Remember nobody is bigger than the market.

He pulled this from Michael Batnick’s post about how when you were born dominates your investment performance. (Link)

Be humble about what is actually in your control and structure your life as best you can within that understanding. This thing we call the market is a tyrant. Nobody can live outside what it allows for. This is true of all markets. Consider most businesses. A dumb realtor in a bull market vs a smart realtor in the recession. The market is the biggest factor. This gives credence to the strategy of trying to put yourself in front of the wave of a growing industry. I can see you smart people stewarding “run-off” industries solemnly nodding.

How about the labor market? This is bonus season on Wall Street so lots of little violins playing for people who felt they got screwed. But screw you once, shame on them. Screw you twice? Shame on you. If you don’t leave a crappy employer then you have validated your place in the market. Management is not bigger than the market. If they really screwed you, you can appeal to the labor market. Your boss only gets one swing at your pinata. If you let them take more then perhaps you’re at the only party in town.

2) Morgan Housel’s latest about the psychology of the country leading up to the Great Depression is instructive. (Link)

A timeless takeaway:

The problem when studying historical events is that you know how the story ends, and it’s impossible to un-remember what you know today when thinking about the past. It’s hard to imagine alternative paths of history when the actual path is already known. So things always look more inevitable than they were.

The post is worth a full read. Learn how the collective mindset of the country changed in the decade after WWI and the Spanish Flu. American despair gave way to prosperity before lapsing into the worst economic disaster in US history. He relies on newspaper clippings to provide the real-time perspective countering our hindsight view.

Here’s the nuggets that seem to have burrowed into my long-term memory since reading it:

  • The stock market fell 89% from the peak and took 25 years and another world war before it got back to it’s 1929 level. Birth rates fell 17%. Sobering. Especially when you consider what the path of something like that looks like. If you had bought stocks down 80% from the highs, by the time they got to the lows you were down 50% on your money.
  • The 1920s seemed to be the cradle of how American’s think of prosperity even today. I take it for granted when apparently it has roots that are less than 100 years old.

Investing lessons written in blood shouldn’t fade. This post will stay with me.

How Tails Constrain Investment Allocations

You would need to be living under a rock to not know about the importance of small probabilities on asset distributions. By 2020, every investor has been Talebed to death by his golden hammer. But knowing and understanding are not the same. I know it’s painful to give birth. But if I claimed more than that I’d end up only understanding what it felt like to be slapped in the face.

I’m hoping the above discussion of the devilish nature of small probabilities makes the seemingly academic topic of fat-tails more visceral. But if it didn’t I’m going to try to drive it home in the context of a real-life investing decision.

Step 1: Understand the impact of fat tails

I ran a simple monte carlo assuming the SPX has a 7% annual return (or “drift” if you prefer to sound annoying). I assume a 16% annual vol or standard deviation and ran a lognormal process since we care about geometric returns. We’ll call this model the “naive simulation”. It does not have fat tails.

Based on these parameters, if you invest on January 1st:

  • You have a 5% chance of being down 23% at some point during the year.
  • You have a 50% chance of being down 7% at some point during the year.

Now be careful. These are not peak-to-trough drawdowns. They are actually a subset of drawdown since they are measured only with respect to your Jan 1st allocation. The chance of experiencing peak-to-trough drawdown of those sizes is actually higher, but these are the chances of your account being X% in the red.

That’s the naive simulation. To estimate the odds in a fat-tailed distribution we can turn to the options market which implies negative skewness and excess kurtosis (ie fat tails). I used 1-year option prices on SPY. Option prices answer the question, “what are the chances of expiring at different prices?” not “what are the chance of returning X at any point in the next year?”. To estimate what we want we will need to use the pricing from strikes that correspond to the equivalent one-touch option. Walking through that is overkill for this purpose but hit me offline if you want to see how I kluged it.

Let’s cut to the market-implied odds.

  • You have a 5% chance of being down 39% at some point during the year.
  • You have a 50% chance of being down 11% during the year.

Now you can see the impact of fat-tails: the gap between 23% and 39%. This is the impact of kurtosis in the options. Meanwhile, in the heart of the distribution, the downside moves from 7% to 11%. Not as dramatic and attributable to market skew.

When we shift probabilities in the tails of distribution vs the meat the impact on the payoffs is significant.

Repeating this insight in a different way may help your understanding. Consider tossing a pair of dice. Imagine playing a game that pays the fair odds for a roll (i.e. craps).

Now let’s chip the dice to change the probability of how they land.

  • In scenario 1, add 1% to the “7” and shave .5% from each tail.
  • In scenario 2, add 1% to the “7” and shave .5% from the meat, the “6” and “8”

By shaving from the tails we take a fair game and turn it into a negative 30% expected value per toss. This is far worse than almost any casino game you might play. By changing the tail probabilities the effect on the game is magnified because the odds are multiplied across an inversely proportional payoff!

Step 2: How should tail sensitivity affect allocations?

By now, the danger of poorly estimating should be a bit more clear. How do we use this when making allocation decisions? After all, most of the time whether they are 1% or 2% events, huge moves are usually not in play. But we must care because when these events hit the impact is huge.

Tail outcomes should dictate constraints based on what you can tolerate. I’ll work through a conservative framework so you can see the impact of naive tail probabilities versus market-implied tail probabilities. The exact answers don’t matter but I’m hopefully offering a way to make tail-thinking relevant to your allocation decisions.

Reasoning through sizing decisions

Suppose things are going well and you are able to save $50,000 per year after paying expenses. You decide that losing $50,000 in the stock market is the largest loss you can accept, reasoning that it’s a year’s worth of savings and that you could make up the lost sum next year. If you impose a restraint like that, well, the most you can allocate to stocks is $50,000. That’s too conservative especially if you have accumulated several hundred thousand dollars in savings.

So you must relax your tolerance. You decide you are willing to accept a $50,000 loss 5% of the time or 1 in 20 years. Roughly a generation. If we use the naive model’s output that we lose 23% of our investment with 5% likelihood then the maximum we can allocate to stocks is $50,000/.23 = $217,000.

The naive model says we can allocate $217k to stocks and satisfy our tolerance of losing $50k with 5% probability. But if the market’s fat-tails are implied more accurately by the option skew, then our max allocation can only be $128k ($50,000/.39).

If we constrain our allocation by our sensitivity to extreme losses, the max allocation is extremely sensitive to tail probabilities. In this example, we simply varied the tail probability between a naive model using a mean and variance to a market-implied model which adjusted for skew and kurtosis. The recommended allocation based on our tolerance dropped a whopping 42% from $217k to $128k.

Many will point out that this approach is extremely conservative. Constraining your max loss tolerance to the amount of money you can save in a year seems timid. But the probabilities we used here did understate the risk. Again these were not peak-to-trough drawdown probabilities but the narrower chance of incurring losses on your start of year allocation. If we are thinking about the true experience of investing and how you actually feel it, you probably want to consider the higher drawdown probabilities which are out of scope for a piece like this. I know many financial advisors read this letter, I’m curious how allocation models reason through risk tolerance.

Current examples to consider in context of small probabilities

1) Bernie

There are market watchers who believe that electing Bernie Sanders would send us back to living in caves. Democrats are trading for about 40% to win the election. Bernie is trading at about 45% to win the nomination, implying an 18% chance to win the election. Market watchers who fear a Bernie presidency are either totally overstating his alleged market impact or the market is already discounting his odds. If the latter is true and the market is efficient, math dictates that it should shoot much higher in the event he loses.

At 18%, Bernie is no longer in the tail of the distribution. So you could argue that as he went from single-digit probability to his current chances, the market strongly re-calibrated either his impact or the sustained rally in the meantime would have been much larger. One of these things must have happened by the necessity of math as odds shifting from a few percents to 18%.

Or there is a third option. The market never really believed that Bernie’s impact would be as deep as his detractors contend.

2) Tesla

We have all seen this stock double in the past month. There has been a lot of talk about far out-of-the-money call options trading on the stock. These are bets on the upside tails of the stock over relatively short time frames. I won’t comment too much on that other than to point out a different tail in the matter. All the credit for this observation goes to a friend who keenly remembered that a year ago the Saudi’s collared their position in TSLA. That means they bought puts and financed by calls sold on the stock. Given the size of the move, the calls they sold are definitely deep in the money. This hedge likely cost them over 3 billion dollars. Billion with a “b”. That’s 6% of there projected government deficit. Their investment in TSLA stock was supposed to be a tail hedge against electric cars destroying demand for oil permanently. In the meantime, they got smoked hedging the hedge. The other tail in this story is going to be that of the official who recommended the hedge. This is a government that nearly executed a 13-year old for protesting. Fair warning to anyone looking to be an execution trader for the kingdom. You are probably short the mother of all puts. Make sure you are getting paid at least as much as a logger.

And one last TSLA note. This keen observation by Professor Bakshi.

Sometimes Keynes’ beauty contest doesn’t just judge beauty. It can create it.

Market Mutations

recently described markets as biology not physics in recognition of how players adapt. Let’s discover 2 more opaque examples and their causes.

1) Structured products

Historically your bank would happily sell you an investment note which guarantees your principle (insofar as you are ok with your bank’s credit risk) and earns you a return which is linked to return of an equity index. To manufacture this investment product the bank would invest in bonds and a portion of the interest income would be directed to buy call options on the index. There are more shortcuts they use to create the product (for example, the investor typically doesn’t capture the dividends which are a significant portion of the expected return), but the important thing to understand is these notes require enough interest income to finance the call options. With interest rates near zero in most of the world, banks have had to get more…creative.

To keep these notes promising attractive rates of return, the issuers buy insurance against a sell-off from the investors. Not explicitly of course. Instead they embed a feature that “knocks” your note out and exposes you to the losses if the reference index falls far enough. Yes, the prospectus spells this out. But for whatever reason, retail investors fail to wonder why an investment product can offer seemingly attractive returns in a low risk-free rate environment. They continue to gobble them up, not realizing they are self-financing these returns by underwriting catastrophic risk.

Here’s where it gets interesting. Since interest rates have never been this low and the aging developed nations have never been this large, there is unprecedented demand for these notes. These products are intensely popular in Asia and Europe (a friend once quipped you could buy them at a 7-11 in Italy. I want to believe this because it sounds so ridiculous so I refuse to fact-check it). The issuing banks, who are not in the business of taking directional or outright volatility risk, must recycle the optionality that these notes spit off. The associated option flows from these popular products are correspondingly massive.

From a “market is biology” perspective, it’s useful to remember that anybody using historical data to make their case may not be fully appreciating that our current landscape includes a bunch of dormant, non-linear payoffs that kick in only when the market has already made a large down move. An extreme analogy would be like comparing NFL wide receivers through time without noticing that they got rid of pass interference rules.

Although the bulk of these notes have historically been tied to Asian indices like Korea, they are becoming increasingly linked to the SP500. Will the tail wag the dog? Let options fund manager Benn Eifert explain on his latest appearance on the Bloomberg Odd Lots episode titled How To Create Havoc In The U.S. Options Market. (Link)
2) How corporate governance responds to the age of passive indexing
Consider these points taken from Farnum Street Investment’s latest letter. (Link)

  • In 1965, the CEO-to-worker pay ratio was 20-to-1. By 2018, it had jumped to 278-to-1. How did pay structures get so lopsided? Shouldn’t someone have stepped in? Yes, someone should have stepped in: the owners of the companies. But if you’re a passive index holder, you abdicated that responsibility to Vanguard, Blackrock, State Street or Fidelity. It wasn’t a custodian like Vanguard’s job to mind the henhouse. It was the job of the owners of the company.

Hard Truth: If you own an index fund, you waive your right to complain about CEO compensation.

  • In 2019, Lyft went public. With the increased transparency of SEC filing, it was discovered the company had 46 million restricted stock units (RSU) outstanding. RSUs are a way to incentivize employees, but they can become a big bill for owners. In the case of Lyft, the RSUs would cost owners $2-4 billion, depending on the IPO price. This represented a 20-25% ownership stake of the company being granted to employees. Corporations who grant extravagant stock options do so at the expense of the owners. There are no free lunches.

Hard Truth: If you own an index fund, you waive your right to complain about option dilution.

  • From 2008-2017, the pharmaceutical giant Merck distributed 133% of profits back to shareholders via dividends and share buybacks. Yes, they paid out more than they took in. Those resources could have gone toward research, saving lives, and the next blockbuster drug. The strategy seems obviously shortsighted. How come no one stepped up to tell them to think long term? Analysis initiated by SEC Commissioner Robert Jackson Jr. revealed that in the eight days following a buyback announcement, executives on average sold five times as much stock as they had on an ordinary day. Management is effectively cashing out at the owners’ expense when they know the price will be supported by internal buybacks. How come no one is stopping them?

Hard Truth: If you own an index fund, you waive the right to complain about myopic corporate strategy and share buybacks.

  • Sir Winston Churchill once said, “Capitalism is the worst economic system, except for all the others.” That remains true, but proper capitalism requires thoughtful stewards, meritocratic outcomes, and engaged owners. If we all abdicate our responsibilities, we risk perversion of the system that’s created more positive effects for humanity than arguably any other single phenomenon. Hope is not lost as history tends to move in cycles. We’re in need of the pendulum to change direction.

Hard Truth: This too shall pass.

Markets Will Permanently Reset Higher (My Sacrifice to the Delta Gods)

The US stock market rallied 30% in 2019. A blow-off performance punctuating a decade long bull market.

Professional money managers are pissed.

The Most Hated Rally

“Smart” money said we were in the late innings. Any bit of caution in the portfolio means you are now staring at a poor comparison to the benchmarks. I suspect the quant managers who might be evaluated on risk-adjusted returns are no happier. The rally has been steady. Low volatility. The SPX has won gold in both the absolute return and Sharpe ratio Olympics.

Relative Pain

Active managers are getting rocked. The Fidelity/Vanguard/Schwab race to the bottom on fees and the merit of indexing has been delivering brutal blows to the relative return crowd (mutual funds) and risk-adjusted return crowd (hedge funds) alike. Throw in a dose of market reflexivity and you can imagine the flight to passive strategies accelerating.

Absolute Gain

If you are an individual investor, you probably underperformed, but at least you are winning. And probably a lot more than you imagined. Your investments are an extension of your savings which you’d like to see grow to meet your future liabilities whether it’s a retirement or college fund. Measured against your realistic needs, you are sitting pretty. You would have happily locked in a guaranteed 10% return for 2019 if offered the chance on Dec 31, 2018.

Even More Expensive

Now what? If smart folks, you included, thought markets were expensive last year, you can only feel more dissonant today. We’ve all seen the CAPE charts reminding us that the stock market hasn’t been this expensive since 1999. Well, that was true one year ago as well, and look how 2019 turned out. I could compile a bunch of links showing how CAPE is a useless timing tool on any sub-10 year horizon and perhaps even longer than that.

You can drive yourself crazy and get nowhere asking how long expensive markets will march higher. No serious market observer pretends to have a high confidence answer to that question. If there was an answer it is tormenting allocators and money managers alike. Like Poe’s raven call “nevermore”.

How about the question of why are they rallying? To say more buy volume than sell volume is correct, but not especially useful. Going beyond that, you will not find a shortage of theories. The most popular, based on my state-of-the-art NLP analytics (otherwise known as browsing #fintwit), is the Fed. Central bank easing, best embodied by zero or negative interest rates in Europe and Japan, seems to be public enemy number one. Another alleged culprit has actually been passive indexing itself. This makes intuitive sense as a driver of marginal demand for shares since pulling money from active managers to allocate to say the SP500 is almost certainly going to be increasing the beta of investors’ portfolios if it is done on a dollar neutral basis. Michael Burry, of Big Short fame, has even called passive indexing a bubble.

But What If We’re Wrong

I borrowed the heading from the title of Chuck Klosterman’s book urging us to soften our attachment to the premises upon which we have built conventional wisdom. If this were easy to do he wouldn’t have needed to write a book. Blind spots are so-called for a reason.

Consider the central bank recklessness and passive indexing arguments. These appear to be reasonable explanations for how the market can be artificially or irrationally expensive. They even appear to have endpoints.

Consider these un-timeable reckonings for the central bank argument:

  • Asymmetric, short term nature of political incentives leads to hyperinflationary pressures climaxing in eventual fiat heat death. Creditors destroyed.

or perhaps…

  • A conservative central bank, inspired by the still-vibrant ghost of Volcker, tightens in response to creeping inflationary pressures. Since soft landings don’t exist, the market crashes and our record outstanding debt now teeters on a severely marked down asset base. A deflationary spiral.

How about the “bubble in passive investing” argument?

  • Eventually the inflows to passive will tip so far that active management’s price discovery process will fail to function. There won’t be enough wolves to keep the deer population in check and nature’s equilibrium will breakdown. A litany of price distortions from faulty signals will mirror how natural disasters’ can stem from unintended sequences. It’s like a climate crisis for asset pricing.

These arguments are promoted by many smart people. I’m in no position to falsify them. But I don’t think they necessarily warrant high confidence. First of all, a persistently expensive market is a complex phenomenon so there is a major burden of proof on any reductionist take that I don’t think either of these arguments has satisfied. Furthermore, the incentives of its promoters are enough to cast reasonable doubt on these arguments. To open ourselves to new reasons for the market’s relative expensiveness let’s loosen the grip on the above explanations.

Opening Our Minds

We can attack the central bank and passive indexing arguments on common ground. Both rely on a belief that the market is distorted by significant flows (whether central bank support or migration to passive). They invoke limits to liquidity and arbitrage as reasons for market inefficiency. The argument is compelling. But it’s also epistemologically diabolical in the same way that conspiracy theories recursively gnaw at the logic which allows you to dispel them in the first place.

As mathematician Jordan Ellenburg1 puts it:

“If you do happen to find yourself partially believing a crazy theory, don’t worry — probably the evidence you encounter will be inconsistent with it, driving down your degree of belief in the craziness until your beliefs come in line with everyone else’s. Unless that is, the crazy theory is designed to survive the winnowing process. That’s how conspiracy theories work.”

Those blaming passive indexing and central banks are almost certainly believers in efficient markets. Their arguments follow as so:

  • “Markets are mostly efficient.”
  • “My strategies exploit the few inefficiencies there are.”
  • “My strategies don’t work anymore.”
  • “The markets are inefficient because of X and Y”.

Well, the final conclusion is unmistakably self-serving. Building the argument in steps, the null conclusion should be, “the market, perhaps partially thanks to my work has ironed out the inefficiency I was exploiting.” The prize for this win is an incremental gift of price discovery to the world. And the checks they already cashed. But so much for their future prospects. They can ruminate a bit more on that on their yacht with all their newfound free time.

This Hurts All Investors Not Just Active Managers

If the market is indeed searching for a much higher setpoint then anyone young or who cares about someone who’s young should be concerned.

Investor Lyall Taylor 2 explains:

Most stock market investors worry incessantly about the risk of a potential market melt down. I don’t. I worry about the risk of a market meltup.

For anyone trying to grow their capital; make a living off their investments; or build a business around managing (and making money for) other investors, the absolute worst thing that could happen would be if markets everywhere were to surge and become (and remain) extremely expensive. Imagine, for instance, a world in which stocks traded at 50x earnings. If you invested, you would be offered a poultry 2% earnings yield in exchange for considerable risks.

If markets were to melt up to 50x, it would feel good for a while (if you were invested). However, your future stream of dividends would not have increased, so in truth you would be no wealthier, and furthermore, you would be confronted with the reality of poor reinvestment returns on dividends and corporate stock buybacks. In the long run, this would make you worse rather than better off, despite feeling wealthier in the short run. Bond investors understand reinvestment risk, but most stock investors do not seem too. But it works the same way for stocks as it does for bonds. 

If you’re invested, you are hedged somewhat against the risk of a melt up (a risk most people don’t identify). You can lock in a reasonable return at today’s reasonable prices, and would suffer only on the reinvestment side (an unhedgeable risk). The disaster situation would be to be sitting in cash while watching markets surge all the way to 50x.

If this scenario sounds implausible, consider that we are already facing zero or negative yields in large segments of the bond and real estate markets (reports of easing cap rates in coastal US cities notwithstanding).


  • Compared to history the market is expensive.
  • The most popular explanations rely on some market- distorting mechanisms to justify valuations.
  • The implication is there should be some reversion.

But as investors, we know that markets have a habit of choosing the path which causes the maximum pain for the most people. And it’s pretty clear that valuations ripping higher from here and pushing risky yields even lower would be a world of pain for investors and owners of capital.

Towards New Explanations for Expensive Markets

Option market makers use the expression “make a sacrifice to the delta gods”. In the course of market-making, option traders, despite trying to maintain a flat delta, may end up short an underlyer. When it goes against them, in a misguided effort to not lock in a loss, they will often cover a small portion of the position hoping Mr. Market makes a fool of the most recent purchase by pushing the underlyer back down thus minimizing their loss on the entire position. “I covered a part of the short at a high price but made a lot back on the rest”. Hence, the sacrifice to the gods.

Save me the lecture on investor bias. I’m just sharing what amounts to trader gallows humor. In an effort to make a  sacrifice to Mr. Market, let’s see if there is a case for markets to revalue much higher. Even from here.

For such a justification to be considered, I suggest it:

  • Not rely on significant claims of market inefficiency.

For starters let’s interpret central bank behavior as symptomatic, not causal. It’s not a stretch to believe this.   Many believe demographic-induced secular stagnation stalks developing economies starting with Japan, China, and Europe before coming to the U.S. It’s not impossible to see accommodative policy as being correct given the perceived determinism of shrinking workforces. Taylor actually warns us that focusing on central banks may obscure what is happening. A classic red herring.

Indeed, the ability to blame central banks for any and all bubble-ish behavior may have created a blind spot in markets, and resulted in investors overlooking the other contributory factors I discuss below.

After all, rates that are ‘too low’ are supposed to end in inflation, not deflation. So far they haven’t – in almost a decade – resulted in inflation, which suggests rates may not have been too low after all.

  • Incorporate observations of current market dynamics.

For example, seeing how money managers are throwing in the towel, which is what you would actually predict as they are compared to the market’s amazing risk-adjusted returns. A process that deepens as Soros’ reflexivity sucks remaining investors into passive indexing.

Let’s try to understand what the market is telling us with these high valuations.

Expensive Markets = Cheap Capital

The flip side of lower rates of return is a low cost of capital. Instead of asking why the market is so expensive, let’s ask why is the price of capital so low? For the same reasons that prices are ever low. Some mix of weak demand and ample supply. Capital is subject to the same economic forces as anything you can touch and feel.

Taylor explains:

In short, a combination of a growing supply of savings/capital, and falling demand for the usage of those savings. The scarcity of capital is falling. Scarcity is the foundation of returns in capitalism.

Historically, capital has been scarce (sometimes more than others), and high returns/interest rates have therefore been required to ration it to its most productive uses. However, there is no guarantee that will continue. There is no rule of the universe that says capital is entitled to a decent return (or any return).

Let’s start with the weak demand for capital.

Reduced Demand For Capital

The nature of the real economy has been changing which has reduced the capital intensity of industry. The term “data economy” is often used to signify how we have shifted from moving atoms to moving bits. Back to Taylor:

The world (or the developed world at least) is heading into something of a post-industrial era, where a lot of tangible capital is no longer needed to drive growth in productivity. Innovation is instead happening in technology, software, and services, etc, while incremental consumer demand is for relatively intangible services/experiences/entertainment, rather than ‘stuff’. These two factors are together reducing the demand for new tangible capital stock.

Productivity gains are poorly accounted for justifying the valuations. The growing power of technology is all around us. The only place it is invisible is in the productivity statistics – in my opinion because rapid productivity growth is deflationary, and because new technologies are now resulting in whole industries being demonetized. However, corporations are investing less and less in hard assets because there are comparatively limited opportunities or need for them to do so vis-à-vis the past – particularly with slowing population growth. In short, the ways in which capital can be usefully deployed has been declining, and it is probably structural.

Increasing Supply Of Capital

Taylor provides some economic explanations for the surplus of capital invoking what might be expected from mature economies that have had a good run.

Meanwhile, savings are at elevated levels, and have been for quite some time. This may be for merely cyclical reasons, but it could be partly or wholly due to structural reasons as well. One of the reasons is that wealth and income inequality have been rising rapidly over the past 30 years (something that could be cyclical, structural, or both). The more one earns, the higher one’s propensity to save, and wealthy individuals seldom consume their capital (as opposed to a portion – usually small – of the returns from their capital). Consequently, rising inequality has been increasing the world’s private-sector savings stockpile. In addition, savings-heavy economies such as China have been integrated into the world economy over the past several decades, which has further added to the world’s savings surplus (which was arguably a major contributor to the build up of economic imbalances prior to the GFC).

A Lower Discount Factor

If it weren’t enough that both the supply and demand forces were coordinating to cheapen capital, a lower perception of risk is boosting investment demand. Greed and performance-chasing are timeless behaviors that we would expect a decade into a bull market. Beware. Those explanations, like the Fed excuse, can blind us from looking further. We needn’t look far. The explanation can easily hide in plain sight.


Markets are becoming more efficient. There’s a saying that information wants to be free. It wants to get out. It takes energy to keep useful information private. And if a group has an edge in information, it will be difficult to scale since achieving anything grand requires more people. More people means more leak points. So when we combine information entropy with an explosion of interconnectivity and permissionless platforms, is it any wonder that data, intelligent analysis, and best practices become table stakes?

Increasing Efficiency

  1. Charley Ellis3 of Greenwich advisors on the evolution of investment analysis:

The number of people involved in active investment management, best I can tell, has gone from less than 5,000 to more than 1 million over 56 years. A major securities firm might have had 10 or a dozen analysts back in 1962. What were they doing? They were looking for small-cap stocks and interesting companies that might be interesting investments for the partners of the firm. Did they send anything out to their clients? No, not anything. Goldman Sachs didn’t start sending things out until 1964 or 1965, and there was just one salesman who thought it might be an interesting idea to put out. Today, any self-respecting security firm is worldwide with analysts in London, Hong Kong, Singapore, Tokyo, Los Angeles. 400, 500, even 600 people trying to come up with insights, information, data that might be useful to clients. Anything that might be useful. Demographers, economists, political strategists, portfolio strategist and every major industry team. Every major company will have 10, 12, 15 analysts covering that company. And of course, then if you go to the specialist firms, there are all kinds of people and then there are intermediaries with access to all kinds of experts in any subject you might like. We’ve got 2000 experts. And anytime you want to talk to any one of them, just let us know. Glad to provide an unbelievable, flourishing amount of information of all kinds, all of which is organized and distributed as quickly as possible. Instantaneously, everybody.

2. Now combine this transparency with what pseudonymous writer Jesse Livermore 4 refers to as “networks of confidence.”

Valuation is a function of required rate of return to which liquidity is an input. Imagine a pre-Fed wildcat bank. You would not accept such meager real rates of return because you do not have the confidence in the liquidity of your deposit. So much of our required rates of return come down to confidence. The progress of finance has been towards greater networks levels confidence which creates downward pressure on required rates of return.

3. Finally economist Ed Yardeni 5 describes how capital is so efficiently dispersed throughout the system that distressed funds are on standby waiting to provide liquidity as quickly as opportunity emerges. This private version of plunge protection is like a Nasdaq level 2 bid below the current NBBO. He thinks that absent a broad recession, the market may be able to quarantine sector downturns. Instead of a great recession, we simply adapt to “rolling recessions”. When the US energy sector collapsed in 2015 the fallout was limited as capital was callable on relatively quick notice. If the risk of spillover from sector downturns is limited we can expect fewer recessions, which is what Yardeni attributes any sustained bear market to.

  • Ease of Diversification

First, we need a quick aside on the fact that stocks have historically been a good investment. The excess return of stocks over risk-free rate is known as the “equity risk premium”. The fact that stocks are volatile is used to justify the excess return. Academics often refer to this equity risk premium as a “puzzle” since the return has historically been in excess of what their models would predict. Breaking the Market 6 actually shows that the puzzle is simply an artifact of a false comparison. Academics use index returns as a proxy for “equity returns”. But an index is actually a weighting scheme that rebalances. It’s not the same thing as “stocks”.

“Stocks” and the “Stock Market Index” are not the same thing and never have been. One is an asset class, the other is a trading strategy of that asset class. They don’t behave the same and don’t have the same properties, return, or standard deviation. You can’t use one to replace the other.

When you compare the geometric return of stocks, not a stock index you do not find an ERP!

Ok, with that out of the way, is it now crazy to think that the passive indexing trend which became popular because of its post-fee performance (Ellis reminds us that less than 20% of active managers have beaten passive allocations) will lead to lower excess returns? If they were too high to begin with, increasing access to that strategy should lead to yet lower yields going forward. But here’s the critical point — there’s no reason to expect the yields to revert to the excess levels of yesteryear. Indexing is a  simple word for a weighting strategy that periodically rebalances. The strategy is cheap to implement AND happens to generate an excess return that academics consider excessive. So excessive they call it a risk premium.

So if it’s not stocks that have an ERP but the strategy of stock indexing that actually holds the premium, how is it persisting? The mass adoption of passive you are witnessing is the invisible hand wringing the equity index risk premium out of the market. The lower forward returns the hand leaves behind will be its proof-of-work. According to Vanguard7, in the early 1950s, 4.2% of the population held stocks, and the median number of stocks held was two. The delta from today’s level of investment adoption, especially on a cost-adjusted basis, is a degree of progress more typically associated with tech or medicine.

While democratizing indexing seems like a gift to investors its euphoria will be short-lived. Indexing, by lowering risk discounts, is a more permanent boon to companies and those who need capital. Financial innovation reduces financing friction. Livermore 8 sees this as the march of progress we expect in any other industry. It’s just that the efficiency has been accruing in the direction of those who need capital. Those who supply capital were earning an inefficiency premium. They lacked information, means to diversify, and bore high transaction costs:

The takeaway, then, is that as the market builds and popularizes increasingly cost-effective mechanisms and methodologies for diversifying away the idiosyncratic risks in risky investments, the price discounts and excess returns that those investments need to offer, in order to compensate for the costs and risks, come down.  Very few would dispute this point in other economic contexts.  Most would agree, for example, that the development of efficient methods of securitizing mortgage lending reduces the cost to lenders of diversifying and therefore provides a basis for reduced borrowing costs for homeowners–that’s its purpose. But when one tries to make the same argument in the context of stocks–that the development of efficient methods to “securitize” them provides a basis for their valuations to increase–people object.

Those who need capital ate the cost of the inefficiencies that the underwriters sought payment for via fatter WACCs. The ironing of those inefficiencies is a permanent asset to borrowers and equity issuers.

  • Privilege of Knowledge

If technology has subsidized indexing from the supply side, the “privilege of knowledge” is sparking demand. This privilege, a term coined by writer and data scientist Nick Maggiulli, recognizes that the dominant strategy of buying and holding a rebalanced index was not known until the past 30 years. As Maggiulli explains9:

From 1871-1940, the U.S. stock market grew at a rate of 6.8% a year after adjusting for dividends and inflation. No investor in 1940 could’ve known this, because the data going back to 1871 wasn’t compiled by Robert Shiller and his colleagues until 1989…[if] buy and hold might seem obvious now, that’s only because we have the benefit of hindsight, ubiquitous data, and modern computational resources.

Those same resources that lowered the costs of diversifying also helped spread the word of its efficacy. Indexing is like a technology all its own. Better and cheaper. When you put a product with those features into the world, you are not surprised when it’s pulled not pushed. 10

Expensive For A Reason

The prospect of a sustained reversion in investment yields likely extends beyond the horizon of bargain-hunters’ binoculars. We may look back at historical returns and wonder why investors ever got to have it so good. We will look back and think how inefficient it once was. Can you believe people earned 8-10% in stocks and thought it should last? We may look at equity returns for the past century the way people now look at home prices. Remember when a house only cost 3x annual income? That was cute. As you look ahead, keep Taylor’s scoffs in mind:

Indeed, when you think about it, why should an index fund holder be able to lie on a beach all day and earn 10% a year? If the world needs savings, sure, that’s fine, but if it does not, then those savings ought to earn a materially lower return, if any return at all. And that is the direction the world has been going in.

What can you do about it?

If you have you participated in the re-pricing thus far, congratulations. Now what? Just as adding a 20th pound of muscle takes significantly more energy than the first, the next thousand basis points are going to require way more risk than you’ve endured until now. But to participate in the melt-up scenario the market demands you accept more risk for the same rewards. And if you abstain, Taylor reminds you of the reinvestment risk:

The disaster situation would be to be sitting in cash while watching markets surge all the way to 50x. What would you do then –particularly if the alternative was zero (or negative) rates in the bank? You’d be pretty much stuffed. If you kept holding cash, you’d have to settle for watching your capital slowly dwindle, and if you capitulated and invested, you would risk a major and permanent loss of capital if markets eventually did resettle at lower levels. I have never seen anyone worry about this risk. But they should.

If you are restricted to passive, vanilla strategies you may choose to hold your nose and stay long. I’m not qualified to advise you. But I’ll say that this is a fairly blunt hedge for a melt-up. It’s like tenting your house to get rid of ants. Consider the distribution more closely. If the market is expensive but the price of capital still has ample room to fall, it feels as though both the left and right tail are fatter. This is the solution options were built for. I don’t need to fumigate my house, I just need to shell out for some ant baits.

Evaluate Your Options

1) First the bad news. Listed financial options are probably not the answer. Why?

  • Listed call options maturities don’t match up with long term investors’ horizon (unless you consider 3 years long term). That means this type of hedge requires you get the timing right. The last thing you want is more ways to be wrong.
  • The upward-sloping volatility term structure would ensure premium pricing for the options.
  • While being long the index outright is a blunt hedge, call options, for all their extra hassle, are still not a surgically precise hedge. The right tail we are concerned with is risk premiums shrinking. This can still happen if earnings fall while multiples expand. Imagine earnings falling by 20% and the index only dropping 10%. Multiples will have actually expanded by 12.5%. I admit this sounds unlikely. But we are talking about this as a right tail event. In that context, the forces which are driving the price of capital lower may even accelerate in a recession. The financial option you actually want to buy needs to be struck on the index multiple, not the index level.

So unless a liquid market develops for the SPX 10yr 40 P/E Strike Call, I don’t see a simple financial options hedge.

2) Trend-following the index to replicate an option-like payoff. This strategy has been explored extensively with many variations incorporating momentum and dual momentum. Again, not investing advice, but these are outstanding sources to learn about trend strategies:

The strategies come in many forms but the gist is they keep you invested until the tide turns thus limiting your drawdowns.

Be warned. Trend is not a miracle-drug. You pay for this parachute in transaction costs, both explicitly and via the bid/ask spread of the signal’s entry and exit points. You can think of this whipsaw as the premium you pay for the option-like payoff. While in a financial options contract your premium is known at the outset, the trend whipsaw is a function of the asset’s future volatility and path which are unknowable. Livermore, who has also advocated for trend, makes his own disclaimers. During an interview on Invest Like the Best 11, Livermore cautioned that he is “agnostic” on trend. His creeping doubts about its future efficacy stem from his observation that in recent years there have been more whipsaws and less trend formation, possibly due to the so-called “Fed put”.

3) The last option is the most adventurous and the largest hassle. But it is the option that most directly addresses the root cause of this melt-up scenario. Start a company. If capital is cheap, the market is begging you to be an entrepreneur. I’ve written about this before in The Peace Dividend of Overvaluation.

No More Escape Velocity

So who has the most to gain from hedging the right tail?

The rich.

That it’s so difficult to hedge the right tail may even be a source of comfort for those given to schadenfreude. If the thought of a rentier class that sits back and compounds their wealth advantage for generations rubs you the wrong way then you are rooting for the melt-up. To arrive in a place in which there will be no return without substantial risk. Nassim Taleb12 has argued that the true measure of wealth inequality is the degree to which people are capable of rising or falling from classes. In a world where riskless investments yield zero or negative, nobody’s place is cemented forever. A low-yield future flattens everyone with the rich having the most to lose. Like inflation, the melt-up is a market imposed wealth tax.


In his January 2020 letter, investor Jake Taylor 13 remarks,

The return for the stock market in 2019 was quite odd. The price went up by 30%, yet earnings didn’t budge. All of the change was attributable to “valuation adjustment”.

The market is expensive by any historical measure. We talked about how painful the prospects for re-investment might be if the market marched to higher structural valuations permanently. Like you sprinted out of the gate only to discover you signed up for a marathon, not a 400m dash.

It’s popular to blame central banks, performance-chasing investors, and the rise of passive indexing. But it’s dangerous to presume that these factors are not perfectly rational. If the true equity risk premium is due to re-balance and diversification and that strategy, more commonly known as indexing, is democratized then it should reduce forward expected returns. And without any expectation of reverting to times when we didn’t know better or when that strategy was expensive to access. If capital is less scarce and in less demand it’s price must decline as capital is subject to the same economic forces that set the price of pizza or airfare. If technology cycles 14 and demographics are conspiring to suppress the cost of capital how certain are we that this is irrational?

Like Taylor15, I suspect this melt-up scenario is a tail-risk. As such the proper hedge is some very dirty combination of financial calls, equity trend exposure, and plain vanilla entrepreneurship.

I will leave you with this reminder. I am probably wrong. In fact, if this story ever took hold, sucked everyone in, and instead of the market climbing a wall of worry, ripped higher in a bull capitulation, you can thank me.

My sacrifice to the delta gods brought the rain.