What can two guys from North Dakota tell us about vertical option spreads that we don’t already know? Even if we disregard the tongue-in-cheek geographical slur (and I feel comfortable making it because for a few years I had family ties to North Dakota), the question is misdirected. Vertical Option Spreads: A Study of the 1.8 Standard Deviation Inflection Point by Charles Conrick IV and Scott Hanson (Wiley, 2013) is more about developing a probabilistic trading strategy than about the nuts and bolts of vertical spreads. Which makes it a more interesting book than its generic title would indicate. There are also bonanzas for those who buy the book: a 180-day free trial of Oracle’s pricey Crystal Ball (an Excel add-in for predictive modeling, forecasting, simulation, and optimization) and the authors’ “Amazing Spreadsheet.” In this book they explain in detail how to use both.
Using S&P weekly returns from 1928 to 1989 and its ETF tracker SPY, the authors discovered a window of opportunity. “The area between plus or minus 1.0 and 2.0 standard deviations from the mean return is, in effect, an exact negative of what the normal distribution would predict!” (p. 107) Between plus 1.0 and minus 1.0 standard deviations from the mean there are about 13.2% more data points, between plus or minus 1.0 and 2.0 standard deviations 13.2% fewer data points.
Armed with this statistical information and Crystal Ball’s tools, the authors devised a profitable trading strategy using weekly SPY credit spreads and iron condors. Even though the strategy handily beats the index, it is not wildly profitable, which lends credibility to it.
Despite having probability on their side, the authors are not pure system traders. For example, if there is an upcoming Fed meeting they may trade further out than normal or just stay out of the market until after the announcement. “There is no reason to get into a trade just because you feel compelled to do so. Use good judgment, and make sure all the edges are in place.” (p. 234)
Some of the authors’ trading practices are questionable, which means that this is not the best book for someone who is just starting out in options. There are better places to learn how and when to open and close trades, what brokers to use, and how to manage risk. But for someone who is trying to exploit “improbabilities,” it is a good case study. That you get to play with Crystal Ball for 180 days is icing on the cake.
Monday, September 30, 2013
Wednesday, September 25, 2013
Graham and Emid, Investing in Frontier Markets
Whatever your take on the global markets, especially viewed against the backdrop of Federal Reserve policy, you need to understand the range of products that are available. Investing in Frontier Markets: Opportunity, Risk and Role in an Investment Portfolio (Wiley, 2013) by Gavin Graham and Al Emid introduces readers to one of the least understood asset classes.
For starters, it’s important to define emerging markets as a whole and then to isolate the frontier markets subset. Emerging markets are defined as those countries with a GDP per capita of less than $12,476 that are included in the MSCI Emerging Markets Index. Frontier markets “are investable but have lower market capitalization and liquidity, or more investment restrictions than the more established emerging markets, or both.” (p. 3) Forty countries are included in both the MSCI and S&P frontier market indices—eleven from sub-Saharan Africa, five from Asia, ten from Eastern Europe, six from Latin America, and eight from the Middle East and North Africa. To give a sense of what countries are considered frontier markets, the Asian representatives are Bangladesh, Kazakhstan, Pakistan, Sri Lanka, and Vietnam. The Latin American countries are Argentina, Colombia, Ecuador, Jamaica, Panama, and Trinidad and Tobago.
Why invest in frontier markets? The key benefits, the authors contend, are “diversification, a low correlation with developed markets and the strong likelihood of frontier markets mirroring the development path followed by longer-established emerging markets, thus delivering strong returns to investors with long-term horizons.” (p. 2)
There are reasons to be cautious about investing in frontier markets, however, most notably their recent returns. In the five years ending August 2012 frontier markets have significantly underperformed emerging markets: -9.83% per annum versus -0.07% per annum. Over a ten-year period they returned 8.33%, whereas emerging markets returned 15.35%.
Frontier markets also exhibit high volatility, in part because “there are no, or very few, … institutional investors to offset capital flows generated by individuals and foreign investors.” (p. 75) But high volatility does not imply high portfolio risk because “frontier markets not only have low correlation with developed and emerging markets but very low correlations with each other.” (p. 74)
Let’s say that you would like to invest in frontier markets. What’s the best way to go about it? There are (in order of popularity) global frontier market funds, ADRs, individual equities in multinational companies with major exposure to frontier markets, single-country funds, sector funds, regional funds, and ETFs. The authors recommend using an actively managed global fund with a reasonable expense ratio (2.1%-2.3% per annum). The largest is the Templeton Frontier Markets Fund. Its U.S. version launched in October 2008 and returned 13.45% per annum from inception to the end of 2012 after deducting a 2.15% management expense ratio; during this same period the MSCI Frontier Markets Index had a negative return of 4.98% per annum. Two other outperforming funds are the Harding Loevner Frontier Emerging Markets Fund and the HSBC GIF Frontier Markets Fund. This outperformance is easy to understand. “Given the extremely concentrated and illiquid nature of the frontier market equities that passive investments such as ETFs have to invest in, it is unsurprising that active managers have beaten the indexes. They are inefficient markets where active managers find it much easier to add alpha by virtue of research and taking positions away from the index weightings.” (p. 221)
The most obvious audience for Investing in Frontier Markets is financial advisors who have to explain to clients the pros and cons, the ins and outs, of adding this asset class to their portfolios. They will definitely be better informed after reading this book.
For starters, it’s important to define emerging markets as a whole and then to isolate the frontier markets subset. Emerging markets are defined as those countries with a GDP per capita of less than $12,476 that are included in the MSCI Emerging Markets Index. Frontier markets “are investable but have lower market capitalization and liquidity, or more investment restrictions than the more established emerging markets, or both.” (p. 3) Forty countries are included in both the MSCI and S&P frontier market indices—eleven from sub-Saharan Africa, five from Asia, ten from Eastern Europe, six from Latin America, and eight from the Middle East and North Africa. To give a sense of what countries are considered frontier markets, the Asian representatives are Bangladesh, Kazakhstan, Pakistan, Sri Lanka, and Vietnam. The Latin American countries are Argentina, Colombia, Ecuador, Jamaica, Panama, and Trinidad and Tobago.
Why invest in frontier markets? The key benefits, the authors contend, are “diversification, a low correlation with developed markets and the strong likelihood of frontier markets mirroring the development path followed by longer-established emerging markets, thus delivering strong returns to investors with long-term horizons.” (p. 2)
There are reasons to be cautious about investing in frontier markets, however, most notably their recent returns. In the five years ending August 2012 frontier markets have significantly underperformed emerging markets: -9.83% per annum versus -0.07% per annum. Over a ten-year period they returned 8.33%, whereas emerging markets returned 15.35%.
Frontier markets also exhibit high volatility, in part because “there are no, or very few, … institutional investors to offset capital flows generated by individuals and foreign investors.” (p. 75) But high volatility does not imply high portfolio risk because “frontier markets not only have low correlation with developed and emerging markets but very low correlations with each other.” (p. 74)
Let’s say that you would like to invest in frontier markets. What’s the best way to go about it? There are (in order of popularity) global frontier market funds, ADRs, individual equities in multinational companies with major exposure to frontier markets, single-country funds, sector funds, regional funds, and ETFs. The authors recommend using an actively managed global fund with a reasonable expense ratio (2.1%-2.3% per annum). The largest is the Templeton Frontier Markets Fund. Its U.S. version launched in October 2008 and returned 13.45% per annum from inception to the end of 2012 after deducting a 2.15% management expense ratio; during this same period the MSCI Frontier Markets Index had a negative return of 4.98% per annum. Two other outperforming funds are the Harding Loevner Frontier Emerging Markets Fund and the HSBC GIF Frontier Markets Fund. This outperformance is easy to understand. “Given the extremely concentrated and illiquid nature of the frontier market equities that passive investments such as ETFs have to invest in, it is unsurprising that active managers have beaten the indexes. They are inefficient markets where active managers find it much easier to add alpha by virtue of research and taking positions away from the index weightings.” (p. 221)
The most obvious audience for Investing in Frontier Markets is financial advisors who have to explain to clients the pros and cons, the ins and outs, of adding this asset class to their portfolios. They will definitely be better informed after reading this book.
Monday, September 23, 2013
Lack, Bonds Are Not Forever
As you might guess from its title, Bonds Are Not Forever: The Crisis Facing Fixed Income Investors (Wiley, 2013) is an admonition about investing in bonds under current conditions. Simon A. Lack, who dealt with the fixed income market for many years at J.P. Morgan, is not a bond basher in general. Indeed, bonds have been a good place to be. “Bonds outperformed stocks during the first decade of the millennium, and the buyer of a 30-Year Treasury bond at the peak in yields in 1981 also outperformed equities during the subsequent 30 years.” (p. 189) Now, however, it’s time for bondholders to pull up stakes and move on.
Even though many others have sounded the alarm on bonds, Lack offers a historical framework, anecdotes (at times amusing and at other times scary), and compelling analysis in support of his position.
Here I’ll focus on two related reasons that bondholders should bail. First, “nominal yields that are close to and below inflation ensure that the investor will get back less purchasing power than he gave up when he bought the bonds. Figure in taxes and it’s worse. Moreover, real rates on government and investment-grade credit are unlikely to provide the 2 to 3 percent cushion above inflation that ought to be the minimum requirement of lenders.” (p. 190) Second, “even earning a return on bonds that beats inflation after taxes doesn’t ensure a secure future for those planning their retirement.” (p. 191)
Most people assume that beating inflation means beating the CPI. But there is a disconnect between the CPI and consumers’ daily purchasing experience. As Lack writes, the folks at the BLS “don’t measure what we care about because it’s too hard; they measure what they can, and we mistakenly think they’re counting what counts to us.” (p. 185) For instance, we think they are measuring the cost of owning a home, aka the bottomless pit, but in fact they’re measuring what the home would rent for. Moreover, they construct their index by asking homeowners how much they think their home would rent for, as if homeowners were the ultimate real estate experts. The BLS disregards such things as mortgage rates, property taxes, insurance, and maintenance and measures only utility bills. (Even here, if you heat with natural gas you win; with heating oil, you lose.)
And then there’s the problem of the “hedonic quality adjustment” in the CPI. The BLS doesn’t measure the cost of a constant standard of living but the cost of constant utility. For instance, “if your standard of living includes being able to afford the latest iPad, and the latest iPad costs what the older version did, you don’t feel as if your standard of living has improved. The BLS would record an increase in your utility (because you bought more iPad for $500 than used to be possible), but you’ve simply bought the latest iPad.” (p. 179)
In brief, people who simply keep up with the CPI “will experience a steadily declining standard of living. You’ll have last year’s utility when you really want this year’s to maintain your relative standard of living.” (p. 185)
Where should a bondholder go? Equities are the obvious alternative; holding some cash adds stability to a long-only portfolio. Lack provides two tables to guide the investor, one that shows the percentage of stocks needed to earn an equivalent treasury bond return and another that compares drawdowns in cash and stocks versus bonds.
Even if you’ve heard this song before, Lack offers interesting embellishments. In my opinion the book is worth reading just for the anecdotes. Did you know, for instance, that until 1986 brokers from the British brokerage firm Mullins were required to wear top hat and tails every day on the trading floor? Of course, there’s a lot more to Bonds Are Not Forever than curiosities. It is an insider’s view of what outsiders should know and, as such, should be required reading for every retail bond investor.
Even though many others have sounded the alarm on bonds, Lack offers a historical framework, anecdotes (at times amusing and at other times scary), and compelling analysis in support of his position.
Here I’ll focus on two related reasons that bondholders should bail. First, “nominal yields that are close to and below inflation ensure that the investor will get back less purchasing power than he gave up when he bought the bonds. Figure in taxes and it’s worse. Moreover, real rates on government and investment-grade credit are unlikely to provide the 2 to 3 percent cushion above inflation that ought to be the minimum requirement of lenders.” (p. 190) Second, “even earning a return on bonds that beats inflation after taxes doesn’t ensure a secure future for those planning their retirement.” (p. 191)
Most people assume that beating inflation means beating the CPI. But there is a disconnect between the CPI and consumers’ daily purchasing experience. As Lack writes, the folks at the BLS “don’t measure what we care about because it’s too hard; they measure what they can, and we mistakenly think they’re counting what counts to us.” (p. 185) For instance, we think they are measuring the cost of owning a home, aka the bottomless pit, but in fact they’re measuring what the home would rent for. Moreover, they construct their index by asking homeowners how much they think their home would rent for, as if homeowners were the ultimate real estate experts. The BLS disregards such things as mortgage rates, property taxes, insurance, and maintenance and measures only utility bills. (Even here, if you heat with natural gas you win; with heating oil, you lose.)
And then there’s the problem of the “hedonic quality adjustment” in the CPI. The BLS doesn’t measure the cost of a constant standard of living but the cost of constant utility. For instance, “if your standard of living includes being able to afford the latest iPad, and the latest iPad costs what the older version did, you don’t feel as if your standard of living has improved. The BLS would record an increase in your utility (because you bought more iPad for $500 than used to be possible), but you’ve simply bought the latest iPad.” (p. 179)
In brief, people who simply keep up with the CPI “will experience a steadily declining standard of living. You’ll have last year’s utility when you really want this year’s to maintain your relative standard of living.” (p. 185)
Where should a bondholder go? Equities are the obvious alternative; holding some cash adds stability to a long-only portfolio. Lack provides two tables to guide the investor, one that shows the percentage of stocks needed to earn an equivalent treasury bond return and another that compares drawdowns in cash and stocks versus bonds.
Even if you’ve heard this song before, Lack offers interesting embellishments. In my opinion the book is worth reading just for the anecdotes. Did you know, for instance, that until 1986 brokers from the British brokerage firm Mullins were required to wear top hat and tails every day on the trading floor? Of course, there’s a lot more to Bonds Are Not Forever than curiosities. It is an insider’s view of what outsiders should know and, as such, should be required reading for every retail bond investor.
Thursday, September 19, 2013
Maxwell, Sometimes You Win—Sometimes You Learn
We’ve all read innumerable times that we learn more from failure than from success. Well, that’s not quite accurate. The sentence should probably read: “Failure provides a better opportunity for learning than does success.” Not all people—in fact, probably few people, take advantage of the opportunity that failure offers.
John C. Maxwell, a prolific author of self-help books, wants to increase the number of learners. Sometimes You Win—Sometimes You Learn: Life’s Greatest Lessons Are Gained from Our Losses (Center Street/Hachette, October 2013) explains how to turn failure into learning. John Wooden wrote the foreword to the book, based on its outline, a few months before he died.
Losses are tough, there’s no getting around this fact. They cause us to become emotionally stuck and mentally defeated, they create a gap between knowing and doing, they never leave us the same. They hurt, but when we don’t learn from them they really hurt.
Maxwell approaches learning from multiple perspectives: the foundation of learning, the focus of learning, the motivation of learning, the pathway of learning, the catalyst of learning, the price of learning, and the value of learning. His final chapter is entitled “Winning Isn’t Everything, But Learning Is.” He incorporates anecdotes, insights from others, and apposite quotations such as Bill Gates’s famous line: “Success is a lousy teacher. It makes smart people think they can’t lose.”
Here is one point that traders should appreciate (and act on): don’t let a bad experience become a worse experience. Maxwell recalls ABC’s Wide World of Sports, which used to open with a narrator intoning “the thrill of victory … the agony of defeat.” To illustrate the latter, Maxwell writes, “it always showed a ski jumper heading down ramp, and then suddenly going off course, spinning, crashing through the supporting structure, and then bouncing on the ground. It looked like a horrendous crash. What most people didn’t know was that the skier’s fall wasn’t an accident. He chose to fall rather than to finish the jump. An experienced jumper, he realized that the ramp had become icy, and he was picking up so much speed that if he completed the jump, he would probably land far beyond the sloped landing area and hit level ground, which might have killed him.” (pp. 133-34) By comparison a losing trade, even one not cut short, seems tame indeed. But the same principle applies.
Traders who want to be successful should commit to a regimen of unlearning things that aren’t working. This is a difficult task because, as a leadership coach wrote, “When you are frightened, you calcify your attitudes and beliefs—you resort to the familiar and close your mind. New learning is impossible, and effectiveness is impaired. … Unlearning is prerequisite for growth. … To unlearn, you: 1) admit that an old practice, belief, or attitude is not solving the current problem and that doing more of it won’t lead to desired outcomes; 2) open your mind …; 4) commit to terminating the old way forever; and 5) practice and perfect the new way.” (p. 151)
Maxwell’s book is a good read. Translating learning into acting is, of course, a big step, involving the cultivation of good habits. But we can’t afford not to try. Nobel Peace Prize winner Fridtjof Nansen’s encouraging words might help: “Have you not succeeded? Continue! Have you succeeded? Continue!” (p. 167)
John C. Maxwell, a prolific author of self-help books, wants to increase the number of learners. Sometimes You Win—Sometimes You Learn: Life’s Greatest Lessons Are Gained from Our Losses (Center Street/Hachette, October 2013) explains how to turn failure into learning. John Wooden wrote the foreword to the book, based on its outline, a few months before he died.
Losses are tough, there’s no getting around this fact. They cause us to become emotionally stuck and mentally defeated, they create a gap between knowing and doing, they never leave us the same. They hurt, but when we don’t learn from them they really hurt.
Maxwell approaches learning from multiple perspectives: the foundation of learning, the focus of learning, the motivation of learning, the pathway of learning, the catalyst of learning, the price of learning, and the value of learning. His final chapter is entitled “Winning Isn’t Everything, But Learning Is.” He incorporates anecdotes, insights from others, and apposite quotations such as Bill Gates’s famous line: “Success is a lousy teacher. It makes smart people think they can’t lose.”
Here is one point that traders should appreciate (and act on): don’t let a bad experience become a worse experience. Maxwell recalls ABC’s Wide World of Sports, which used to open with a narrator intoning “the thrill of victory … the agony of defeat.” To illustrate the latter, Maxwell writes, “it always showed a ski jumper heading down ramp, and then suddenly going off course, spinning, crashing through the supporting structure, and then bouncing on the ground. It looked like a horrendous crash. What most people didn’t know was that the skier’s fall wasn’t an accident. He chose to fall rather than to finish the jump. An experienced jumper, he realized that the ramp had become icy, and he was picking up so much speed that if he completed the jump, he would probably land far beyond the sloped landing area and hit level ground, which might have killed him.” (pp. 133-34) By comparison a losing trade, even one not cut short, seems tame indeed. But the same principle applies.
Traders who want to be successful should commit to a regimen of unlearning things that aren’t working. This is a difficult task because, as a leadership coach wrote, “When you are frightened, you calcify your attitudes and beliefs—you resort to the familiar and close your mind. New learning is impossible, and effectiveness is impaired. … Unlearning is prerequisite for growth. … To unlearn, you: 1) admit that an old practice, belief, or attitude is not solving the current problem and that doing more of it won’t lead to desired outcomes; 2) open your mind …; 4) commit to terminating the old way forever; and 5) practice and perfect the new way.” (p. 151)
Maxwell’s book is a good read. Translating learning into acting is, of course, a big step, involving the cultivation of good habits. But we can’t afford not to try. Nobel Peace Prize winner Fridtjof Nansen’s encouraging words might help: “Have you not succeeded? Continue! Have you succeeded? Continue!” (p. 167)
Wednesday, September 11, 2013
Cowen, Average Is Over
In this new Dutton release Tyler Cowen, a professor of economics at George Mason University, analyzes today’s economic reality in which Average Is Over. In its place is a world of income disparity, with big earners and big losers. This dichotomy, Cowen argues, is not likely to change in the future. Although the subtitle of the book is Powering America Beyond the Age of the Great Stagnation, future economic growth will not provide more wage equality. Since the source of this power is the use of new technologies, the economic divide will in fact only be exacerbated: “Marriages, families, businesses, countries, cities, and regions all will see a greater split in material outcomes; namely, they will either rise to the top in terms of quality or make do with unimpressive results.” (p. 4)
It’s not the case, writes Cowen, that the middle class has been decimated, but “the middle of the distribution is thinning out and this process appears to have a long ways to run. … The longer-term trend is fewer jobs in middle-skill, white-collar clerical, administrative, and sales occupations. Demand is rising for low-pay, low-skill jobs, and it is rising for high-pay, high-skill jobs, including tech and managerial jobs, but pay is not rising for the jobs in between.” (pp. 38-40) Fret not, finance remains one of those areas that recruits freshly minted college grads with a high ‘g factor’—i.e., high general intelligence (even if not high skill)—and pays them well.
What will the United States look like in twenty to forty years? Extrapolating from the present, Cowen argues that “we will move from a society based on the pretense that everyone is given an okay standard of living to a society in which people are expected to fend for themselves much more than they do now.” He imagines “a world where, say, 10 to 15 percent of the citizenry is extremely wealthy and has fantastically comfortable and stimulating lives…. Much of the rest of the country will have stagnant or maybe even falling wages in dollar terms, but a lot more opportunities for cheap fun and also cheap education. Many of these people will live quite well, and those will be the people who have the discipline to benefit from all the free or near-free services modern technology has made available. Others will fall by the wayside. … It will become increasingly common to invoke ‘meritocracy’ as a response to income inequality” and this “framing of income inequality in meritocratic terms will prove self-reinforcing. Worthy individuals will in fact rise from poverty on a regular basis, and that will make it easier to ignore those who are left behind.” (pp. 228-230)
The future Cowen paints is pretty bleak for the majority of Americans. For instance, “the less wealthy will be pushed out of the nicer living areas.” He contemplates the possibility of building some makeshift structures for the poor, including the elderly poor, “similar to the better dwellings you might find in a Rio de Janeiro favela. The quality of the water and electrical infrastructure might be low by American standards, though we could supplement the neighborhood with free municipal wireless….” (p. 244)
This is not a future I want to see. We can only hope that, as often happens, trends are disrupted.
It’s not the case, writes Cowen, that the middle class has been decimated, but “the middle of the distribution is thinning out and this process appears to have a long ways to run. … The longer-term trend is fewer jobs in middle-skill, white-collar clerical, administrative, and sales occupations. Demand is rising for low-pay, low-skill jobs, and it is rising for high-pay, high-skill jobs, including tech and managerial jobs, but pay is not rising for the jobs in between.” (pp. 38-40) Fret not, finance remains one of those areas that recruits freshly minted college grads with a high ‘g factor’—i.e., high general intelligence (even if not high skill)—and pays them well.
What will the United States look like in twenty to forty years? Extrapolating from the present, Cowen argues that “we will move from a society based on the pretense that everyone is given an okay standard of living to a society in which people are expected to fend for themselves much more than they do now.” He imagines “a world where, say, 10 to 15 percent of the citizenry is extremely wealthy and has fantastically comfortable and stimulating lives…. Much of the rest of the country will have stagnant or maybe even falling wages in dollar terms, but a lot more opportunities for cheap fun and also cheap education. Many of these people will live quite well, and those will be the people who have the discipline to benefit from all the free or near-free services modern technology has made available. Others will fall by the wayside. … It will become increasingly common to invoke ‘meritocracy’ as a response to income inequality” and this “framing of income inequality in meritocratic terms will prove self-reinforcing. Worthy individuals will in fact rise from poverty on a regular basis, and that will make it easier to ignore those who are left behind.” (pp. 228-230)
The future Cowen paints is pretty bleak for the majority of Americans. For instance, “the less wealthy will be pushed out of the nicer living areas.” He contemplates the possibility of building some makeshift structures for the poor, including the elderly poor, “similar to the better dwellings you might find in a Rio de Janeiro favela. The quality of the water and electrical infrastructure might be low by American standards, though we could supplement the neighborhood with free municipal wireless….” (p. 244)
This is not a future I want to see. We can only hope that, as often happens, trends are disrupted.
Monday, September 9, 2013
Baker & Kiymaz, Market Microstructure in Emerging and Developed Markets
Not so very long ago investors and traders had little reason to worry about what goes on behind the scenes. They placed an order, got a fill, paid a commission, and that was that. They didn’t have to know “how the sausage was made.” But times have changed. Infrastructure malfunctions and flash crashes have unnerved the investing community—in part because they (and often the regulators as well) didn’t understand how such disruptions could happen.
Market Microstructure in Emerging and Developed Markets: Price Discovery, Information Flows, and Transactions Costs, edited by H. Kent Baker and Halil Kiymaz (Robert W. Kolb Series in Finance, Wiley, 2013) offers a detailed analysis of the market’s “guts.” Or, more accurately, I should make the word “market” plural because the book covers not only the equity market but bond, derivatives, and currency markets, not only exchanges but dark pools, not only developed markets but emerging markets. Both academics and practitioners contributed to the book.
I can’t, of course, give a proper sense of this book as a whole since it is so wide-ranging, but here are a few topics that are analyzed. Do circuit breakers reduce volatility, enhance price discovery, interfere with the trading process, prompt a magnet effect? Why does the bid-ask spread exist? (Yes, of course, we know the easy answer.) What is the impact of high-frequency trading on liquidity and market quality? How does pretrade transparency affect liquidity? How would you design a market from scratch?
I personally have always been intrigued by dark pools. Put most crudely, are they good or bad? The authors of the chapter on dark trading note that “dark pools free ride on the price discovery of other markets…. This may give rise to manipulation strategies that may negatively affect both dark pools and the main market. Dark pools also influence the market quality of other markets. Two opposite forces appear. First, dark pools allow for additional risk-sharing benefits as they may cater to traders who would otherwise not participate in the trading process. This should improve market quality. Second, market quality may deteriorate when dark pools are skimming off part of the uninformed traders. These trade-offs underpin why regulators are concerned that price discovery and market quality may suffer when the market share of dark pools becomes too large.” (p. 227) And you wonder why regulators have such difficulty coming up with clear guidelines.
For those who want to know where to place their limit orders, here’s a finding from 2004 about quote clustering: “The proportion of quotes that are divisible by $0.05 is around 39 percent for NASDAQ and 40 percent for the NYSE. The proportion of quotes divisible by $0.10 is 22 percent for NASDAQ and 24 percent for the NYSE.” (p. 208)
Market Microstructure doesn’t read like a novel, but it’s an excellent reference for those who would like to delve deeper into how markets do and don’t work.
Market Microstructure in Emerging and Developed Markets: Price Discovery, Information Flows, and Transactions Costs, edited by H. Kent Baker and Halil Kiymaz (Robert W. Kolb Series in Finance, Wiley, 2013) offers a detailed analysis of the market’s “guts.” Or, more accurately, I should make the word “market” plural because the book covers not only the equity market but bond, derivatives, and currency markets, not only exchanges but dark pools, not only developed markets but emerging markets. Both academics and practitioners contributed to the book.
I can’t, of course, give a proper sense of this book as a whole since it is so wide-ranging, but here are a few topics that are analyzed. Do circuit breakers reduce volatility, enhance price discovery, interfere with the trading process, prompt a magnet effect? Why does the bid-ask spread exist? (Yes, of course, we know the easy answer.) What is the impact of high-frequency trading on liquidity and market quality? How does pretrade transparency affect liquidity? How would you design a market from scratch?
I personally have always been intrigued by dark pools. Put most crudely, are they good or bad? The authors of the chapter on dark trading note that “dark pools free ride on the price discovery of other markets…. This may give rise to manipulation strategies that may negatively affect both dark pools and the main market. Dark pools also influence the market quality of other markets. Two opposite forces appear. First, dark pools allow for additional risk-sharing benefits as they may cater to traders who would otherwise not participate in the trading process. This should improve market quality. Second, market quality may deteriorate when dark pools are skimming off part of the uninformed traders. These trade-offs underpin why regulators are concerned that price discovery and market quality may suffer when the market share of dark pools becomes too large.” (p. 227) And you wonder why regulators have such difficulty coming up with clear guidelines.
For those who want to know where to place their limit orders, here’s a finding from 2004 about quote clustering: “The proportion of quotes that are divisible by $0.05 is around 39 percent for NASDAQ and 40 percent for the NYSE. The proportion of quotes divisible by $0.10 is 22 percent for NASDAQ and 24 percent for the NYSE.” (p. 208)
Market Microstructure doesn’t read like a novel, but it’s an excellent reference for those who would like to delve deeper into how markets do and don’t work.
Thursday, September 5, 2013
O’Connell, Stats & Curiosities
The official publication date for Stats & Curiosities from Harvard Business Review, written and edited by Andrew O’Connell (Harvard Business Review Press), is October 15, so consider this a pre-release preview.
Remember the Bangladeshi butter-production theory of asset prices gag? Some twenty years ago David Leinweber and Dave Krider looked for a non-financial series that had the highest correlation with the S&P 500 over a ten-year period. The winner: butter production in Bangladesh. As Leinweber subsequently wrote, “we had a good laugh over it, added a few more dairy products and third world livestock [butter production in the U.S., U.S. cheese production, and sheep population in Bangladesh and U.S.], and lo and behold, found a regression that ‘explained’ 99% of the S&P 500 using this nonsense.” (Forbes, 7/24/2012)
Well, amid the 165 stats and curiosities in O’Connell’s collection, some sound an awful lot like these useless investment signals. And that despite the fact that they stem from serious academic and field studies. Does that mean that the studies were flawed? Or did the researchers unearth genuine connections that occasionally simply seem odd or unnerving? For the most part, I assume the latter is true.
But then, as the author points out, “using legitimate statistical analyses, researchers were able to show in an experiment that participants were nearly 1.5 years younger after listening to the Beatles’ ‘When I’m Sixty-Four’ than after listening to a song that comes with the Windows 7 operating system—an obviously ridiculous finding.” (p. 133)
Moving to less ridiculous (though still odd) findings, “about one-third of drivers of Prius hybrids failed to yield to pedestrians in a series of experiments on crosswalks in the San Francisco Bay area, giving the brand one of the highest rankings for ‘unethical driving.’” (p. 36) Along the same lines, “people who viewed images of food labeled ‘organic’ made harsher moral judgments about others’ behavior and volunteered 6 minutes less of their time to help someone out, compared with people who viewed nonorganic foods.” (p. 44) So much, I guess, for the good earth folks.
A team of researchers from the Federal Reserve Bank of San Francisco studied the link between happiness levels and suicide rates and found that “countries and US states with higher happiness levels tend to have higher suicide rates. … Unhappy people may become suicidally distressed by others’ contentment, the researchers suggest.” (p. 50) Somehow I doubt this interpretation of the data. Findings from two states may prompt readers to formulate an alternative hypothesis: “Utah is ranked number 1 in life satisfaction but has the ninth-highest suicide rate, whereas New York, ranked 45th in satisfaction, has the lowest suicide rate in the United States.”
Here’s another finding that may help to account for the high rate of obesity among the poor. “People who were observed choosing large-size coffees, pizzas, and smoothies were rated by others as having higher status—an average of 4.98 on a 1-to-7 scale—than people who chose small sizes (3.03). … The research shows, moreover, that people who feel powerless tend to choose larger options than people who feel powerful, regardless of the items’ price.” (p. 53)
Some stats that apply directly to the world of finance:
Only 24% of workers in finance and banking would recommend their job to their children as opposed to 67% in agriculture and ranching (presumably they want to keep the family business going), 44% in professional services, 43% in IT, and 42% in health care.
Firms provide more stock options in areas with fewer Protestants.
Negative online chatter volume about company products predicts lower stock prices; positive chatter and five-star ratings have no predictive value.
“Research participants who strongly trusted their feelings were able to predict future levels of the Dow Jones average with 25% greater accuracy than people who didn’t.” (p. 185)
And here’s a truly weird one: “Wide-faced CEOs’ companies perform better.”
So, all of you who are looking for an edge, cast your net wide, be imaginative, but beware the Bangladeshi-butter syndrome or the “fountain of youth” effect of listening to “When I’m Sixty-Four.”
Remember the Bangladeshi butter-production theory of asset prices gag? Some twenty years ago David Leinweber and Dave Krider looked for a non-financial series that had the highest correlation with the S&P 500 over a ten-year period. The winner: butter production in Bangladesh. As Leinweber subsequently wrote, “we had a good laugh over it, added a few more dairy products and third world livestock [butter production in the U.S., U.S. cheese production, and sheep population in Bangladesh and U.S.], and lo and behold, found a regression that ‘explained’ 99% of the S&P 500 using this nonsense.” (Forbes, 7/24/2012)
Well, amid the 165 stats and curiosities in O’Connell’s collection, some sound an awful lot like these useless investment signals. And that despite the fact that they stem from serious academic and field studies. Does that mean that the studies were flawed? Or did the researchers unearth genuine connections that occasionally simply seem odd or unnerving? For the most part, I assume the latter is true.
But then, as the author points out, “using legitimate statistical analyses, researchers were able to show in an experiment that participants were nearly 1.5 years younger after listening to the Beatles’ ‘When I’m Sixty-Four’ than after listening to a song that comes with the Windows 7 operating system—an obviously ridiculous finding.” (p. 133)
Moving to less ridiculous (though still odd) findings, “about one-third of drivers of Prius hybrids failed to yield to pedestrians in a series of experiments on crosswalks in the San Francisco Bay area, giving the brand one of the highest rankings for ‘unethical driving.’” (p. 36) Along the same lines, “people who viewed images of food labeled ‘organic’ made harsher moral judgments about others’ behavior and volunteered 6 minutes less of their time to help someone out, compared with people who viewed nonorganic foods.” (p. 44) So much, I guess, for the good earth folks.
A team of researchers from the Federal Reserve Bank of San Francisco studied the link between happiness levels and suicide rates and found that “countries and US states with higher happiness levels tend to have higher suicide rates. … Unhappy people may become suicidally distressed by others’ contentment, the researchers suggest.” (p. 50) Somehow I doubt this interpretation of the data. Findings from two states may prompt readers to formulate an alternative hypothesis: “Utah is ranked number 1 in life satisfaction but has the ninth-highest suicide rate, whereas New York, ranked 45th in satisfaction, has the lowest suicide rate in the United States.”
Here’s another finding that may help to account for the high rate of obesity among the poor. “People who were observed choosing large-size coffees, pizzas, and smoothies were rated by others as having higher status—an average of 4.98 on a 1-to-7 scale—than people who chose small sizes (3.03). … The research shows, moreover, that people who feel powerless tend to choose larger options than people who feel powerful, regardless of the items’ price.” (p. 53)
Some stats that apply directly to the world of finance:
Only 24% of workers in finance and banking would recommend their job to their children as opposed to 67% in agriculture and ranching (presumably they want to keep the family business going), 44% in professional services, 43% in IT, and 42% in health care.
Firms provide more stock options in areas with fewer Protestants.
Negative online chatter volume about company products predicts lower stock prices; positive chatter and five-star ratings have no predictive value.
“Research participants who strongly trusted their feelings were able to predict future levels of the Dow Jones average with 25% greater accuracy than people who didn’t.” (p. 185)
And here’s a truly weird one: “Wide-faced CEOs’ companies perform better.”
So, all of you who are looking for an edge, cast your net wide, be imaginative, but beware the Bangladeshi-butter syndrome or the “fountain of youth” effect of listening to “When I’m Sixty-Four.”
Tuesday, September 3, 2013
Spitznagel, The Dao of Capital
The Dao of Capital: Austrian Investing in a Distorted World by Mark Spitznagel (Wiley, 2013) is a beautifully crafted book, one I can recommend to readers of all political/economic persuasions. Yes, Ron Paul wrote the foreword and the book will undoubtedly appeal to Fed bashers, but its main line of reasoning transcends ideological divides.
Spitznagel advocates a roundabout (shi, Umweg) approach to investing, which involves “waiting and preparing now in order to gain a greater advantage later.” (p. 3) Admittedly, waiting and preparing can be, and usually is, a painful process. Think of Robinson Crusoe who sacrificed time that could have been spent catching fish by hand or with a crude spear in order to build a simple boat and a fishing net. He went hungry for weeks in order to position himself for a larger catch later on. “This is Umweg: Crusoe ultimately catches more fish by first catching fewer fish, by focusing his efforts in the immediate toward indirect means, not ends.” (p. 110)
Spitznagel develops his thesis by drawing on the wisdom of the Laozi (“the advantage comes not from applying force but from circular yielding”), the paradox of his mentor at the Chicago Board of Trade (“You’ve got to love to lose money, hate to make money, love to lose money, hate to make money…. But we are human beings, we love to make money, hate to lose money. So we must overcome that humanness about us.”), the military strategies of Sunzi and Clausewitz, and—most fully—the writings of the Austrian School.
Spitznagel’s strategy reveals “a clear, systematic source of investment mispricing, ripe for intertemporal arbitrage (a term synonymous with Austrian Investing itself). But this bias of intertemporal inconsistency is not, and for the most part cannot, be arbitraged away, because of the simple reason that the arbitrageurs are the ones most inflicted by the bias.” (p. 158) The problem is that “on Wall Street, roundabout investing—acquiring later stage advantage through an earlier stage disadvantage—is irrational, and acting as if there is no future is perfectly rational” … “No matter how large the ‘later’ might be, the ‘sooner’ is all there is.” (pp. 162-63)
The author devotes two chapters to applied roundabout investing, which in the first instance profits from distortions in the economy and the markets through tail hedging (or at least tips off the retail investor to stay out of the market). He explains how to gauge such distortion using a measure he calls the Misesian Stationarity index. In the second instance he looks for companies that have a high ROIC “where these superior efficiencies at turning invested and reinvested capital into future earnings are apparently not priced in.” (p. 259) The latter is not value investing. “Between Austrian Investing and value investing is again the difference between depth of field and the telescopic long term. … Both require discipline and patience, but Austrian Investing is concerned with the intertemporal process at work, rather than just the endpoint.” (p. 272)
The Dao of Capital is a consistently thought-provoking book. Well, perhaps that’s the wrong adjective since it seems to entail a use of force—and this book aims to twist neither arms nor minds. But it is impossible not to be shaped by its carefully presented history and logic.
Spitznagel advocates a roundabout (shi, Umweg) approach to investing, which involves “waiting and preparing now in order to gain a greater advantage later.” (p. 3) Admittedly, waiting and preparing can be, and usually is, a painful process. Think of Robinson Crusoe who sacrificed time that could have been spent catching fish by hand or with a crude spear in order to build a simple boat and a fishing net. He went hungry for weeks in order to position himself for a larger catch later on. “This is Umweg: Crusoe ultimately catches more fish by first catching fewer fish, by focusing his efforts in the immediate toward indirect means, not ends.” (p. 110)
Spitznagel develops his thesis by drawing on the wisdom of the Laozi (“the advantage comes not from applying force but from circular yielding”), the paradox of his mentor at the Chicago Board of Trade (“You’ve got to love to lose money, hate to make money, love to lose money, hate to make money…. But we are human beings, we love to make money, hate to lose money. So we must overcome that humanness about us.”), the military strategies of Sunzi and Clausewitz, and—most fully—the writings of the Austrian School.
Spitznagel’s strategy reveals “a clear, systematic source of investment mispricing, ripe for intertemporal arbitrage (a term synonymous with Austrian Investing itself). But this bias of intertemporal inconsistency is not, and for the most part cannot, be arbitraged away, because of the simple reason that the arbitrageurs are the ones most inflicted by the bias.” (p. 158) The problem is that “on Wall Street, roundabout investing—acquiring later stage advantage through an earlier stage disadvantage—is irrational, and acting as if there is no future is perfectly rational” … “No matter how large the ‘later’ might be, the ‘sooner’ is all there is.” (pp. 162-63)
The author devotes two chapters to applied roundabout investing, which in the first instance profits from distortions in the economy and the markets through tail hedging (or at least tips off the retail investor to stay out of the market). He explains how to gauge such distortion using a measure he calls the Misesian Stationarity index. In the second instance he looks for companies that have a high ROIC “where these superior efficiencies at turning invested and reinvested capital into future earnings are apparently not priced in.” (p. 259) The latter is not value investing. “Between Austrian Investing and value investing is again the difference between depth of field and the telescopic long term. … Both require discipline and patience, but Austrian Investing is concerned with the intertemporal process at work, rather than just the endpoint.” (p. 272)
The Dao of Capital is a consistently thought-provoking book. Well, perhaps that’s the wrong adjective since it seems to entail a use of force—and this book aims to twist neither arms nor minds. But it is impossible not to be shaped by its carefully presented history and logic.
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