Friday, April 23, 2010

Sometimes Wall Street provides more entertainment than Hollywood: PART 1 the winners

Goldman Sachs as entertainment; stop dancing on graves; make some money instead

Many people take a very narcissistic view of Goldman Sachs (GS) without realizing it. GS serves an audience. But, like the line in the Bob Dylan song says, “It ain’t me babe. No. No. No. It ain’t me.” The idea that a high profile institution exists to serve someone other than them really gets many peoples’ nose out of joint. Many people figure any institution that doesn’t put them at the center of the universe must be evil. It’s as if it has to be a conspiracy since, to their thinking, they should be the center of the universe.

Well, a far more constructive and profitable view exists. The March 30 posting entitled “Wall Street doesn’t run the world” points out that not being the center of the universe creates investment opportunities. In fact, it used a GS recommendation to illustrate the logic. Yet, instead of capitalizing on not being the center of the universe, people persist in believing that if it hurts their ego, it must be hurting their pocketbook. They hurt their pocketbook in the process of protecting their egos.

To see how absurd it can be and to identify some investment opportunities in the process, consider the logical inconsistencies people will tolerate in order to retain their predisposition.

“What are the inconsistencies and how can one make money off of them?” you ask. For starters, in the most generic terms, ignoring information that is inconsistent with a predisposition violates a basic of good investing. Behavioral economists refer to this as looking for confirming information and minimizing non-confirming information. The investment saying is “when your reason for getting in looks wrong, get out.” I prefer: “always question your assumptions” and would add “question other peoples’ assumptions, too.”

That’s all very generic; let’s get to GS. Here’s the inconsistency and how to make it pay. GS received TARP funds, was converted to a commercial bank, borrowed from Warren Buffet at some pretty high rates, and took a pretty big balance sheet loss. All the while, people persisted in believing the “GS runs the world” conspiracy nonsense. Now that’s pretty darn inconsistent unless you think GS was intentionally conspiring to make others rich. In fact, it makes it pretty silly to persist in believing that the financial industry is a game that’s rigged in GS’s favor.

So, here’s the investment theme: “even if you buy into a conspiracy theory, don’t pay money to do it.” A disclosure is in order. About three to six months ago quite a few people were advising to buy GS stock: “they run the world, after all.” Since then, numerous alternatives performed better including the indexes. This isn’t the first time not buying stocks that were the supposed beneficiaries of conspiracy theories facilitated relative performance. Some time after Chaney became VP, it became fashionable to believe that he would conspire with his ex-coworkers to enrich Halliburton. I don’t remember the exact dating, but in that case investing in Halliburton as a trade would have been a disaster. Conspiracy theories are entertainment, nothing more.

Now, consider Gregory Zuckerman’s reporting on John Paulson’s trading. As is making headlines currently because of GS’s role, he made billions by betting that the growth of sub-prime mortgages was a bubble. For a relevant example of Zuckerman’s reporting, consider this item:

What does this item tell us about erroneous conspiracy theories and investing? First, it certainly should put to rest the idea the GS ever ruled the world. Second, the investigation and evidence collection began under one administration and the civil complaint was filed under another. That should call into question efforts to couch the entire issue in partisan political terms. The investment implication is that changes in administration have very little impact on investment risk. Finally, it should raise some questions about the nature of the relationship between politicians and Wall Street. It isn’t always easy to tell who is using whom. That implies that avoiding situations with Washington-based headline risk is an effective risk reduction strategy for most investors.

Truth is, to really get the full benefit of the issue’s ability to provide guidance on investing one should read Zuckerman’s book, THE GREATEST TRADE EVER: THE BEHIND-THE-SCENES STORY OF HOW JOHN PAULSON DEFIED WALL STREET AND MADE FINANCIAL HISTORY. Note that just from the title the basis for one conspiracy theory gets shot down. Wall Street can be profitably “defied.” More importantly, implied by that, and as described in the book, Wall Street isn’t a monolith. Wall Street’s counterparty is often Wall Street; hardly the chummy bunch of insiders populating many conspiracy theories. So, when stocks in Wall Street firms move in lock step, especially as a result of a scandal, somebody is being painted with too broad a brush.

There’s another potential idea for traders. If the investor is willing to take on the risk associated with an investment with a carry-cost (e.g., a short sale or analogous derivatives) or to make a time-dependent trade (e.g., an option), betting against a conspiracy theory is usually a winner. Put differently, one should consider shorting the supposed beneficiary of the conspiracy. But remember, one has to get the timing right as well as to be right. Being proved right after having lost your money may gratify the ego, but egos and investments are two different things. The Zuckerman book was written in late 2009. It took over six months, close to a year, for the impact of the events documented to really hit GS, thus this posting’s preference for avoiding the long rather than initiating a short.

Zuckerman’s book actually goes well beyond just Paulson in describing people making the trade. One thing comes through load and clear: not all the people making the trade could have been a part of any feasible conspiracy. They are just too diverse and scattered a group. Some were secretive about the trade; others were quite proud of it; some viewed others making the trade as a competitive threat; others seemed to sympathize with them as soul mates struggling to make the same trade. Almost all of them viewed their counterparties with suspicion, not as co-conspirators. For investors, the book is a pleasant reminder that when investing one has to think about seller verses seller competition, buyer verses buyer competition, seller verses buyer competition, and buyer verses seller competition.

But more than anything else, the book highlights how difficult it can be to successfully be a trader even when one’s forecast is on target. At this detailed level, the book makes the notion that all successful trades are based on insider information look as foolish as it is. Having the right information failed to be enough for many investors trying to make the trade.

It’s at that detailed level where the book is particularly informative because it highlights some of the skills required to turn good ideas into good investments. To illustrate, getting over-leveraged and consequently not being able to carry the position brought down some traders. When considering shorting a bubble, investors should remember that bubbles often go exponential before busting. Others just initiated the trade too soon. Then they got discouraged and took the trade off just as it started to make money.

Still other people were scared off the trade by dreaming up conspiracies to explain why their trades weren’t working out when they thought was appropriate. It’s dangerous to attribute motives to participants in a trade. It’s foolish to think there is a conspiracy, stupidity, malicious intent, or anything else explaining the entire market. You just don’t know and don’t need to. There’s probably some of each happening as well as differences in objectives and outlooks.

The only example of where understanding motives contributed to successful trades was a motive that’s usually overlooked in conspiracy theories. All of the investors realized that the transaction fees were driving behavior, not the resulting investments. However, that wasn’t necessarily counterparty’s motive; more often it was the middleman’s. Further, they put effort into understanding whether their immediate trade was with a counterparty or a middleman. Conspiracy theorists often overlook, misinterpret, or confuse the distinction. It’s not a good idea for investors to do the same.

Once the people making the trade understood who their counterparty would be, their primary concern wasn’t motive. Their concern was solvency. Getting a commitment to be paid and getting paid are two different things. It’s informative that successful investors worried more about ability to pay than intent. One suspects they relied on the contract to manage intent leaving ability as the open issue and primary concern. Not a bad approach in general.

Counterparty solvency is particularly important when considering investments in derivatives, especially things like synthetic CDOs where collateral is questionable, some would say non-existent.

Finally, the biggest lesson for investors is that all the people making the trade didn’t bother dancing on graves. Rather, they focused on what they could control.

Tuesday, April 20, 2010

Angels, entrepreneurs, and diversification: PART 4

Avoiding the mistakes that are easy to avoid.

Investing in startups is an area of investing with more contradictions than any other. For example, in the context used in these postings investments in startups aren’t as accessible as public company investments. In another sense, anyone can start a business; in fact, one of the reasons startups appear so risky and have such a high failure rate is that just about anyone does. The perspective of these postings, however, isn’t entrepreneurial (i.e., actually starting a business). Rather, the postings address the investment issues.

From an investment perspective, it is important to differentiate issues related to the stock of capital in an asset class from those related to flows into and out of an asset class. To illustrate, a number of recent postings on the VC industry discuss the secondary market (e.g., see: ). They often overlook the possibility that part of the return VCs and their investors receive is a return to holding illiquid assets. If that is the case, then from VCs’ and their investors’ perspectives, a secondary market could undermine their return. That could be aggravated by mark-to-market accounting.

Generally, what leads to this oversight is illustrated by this quote from the citation: “there's more money going in every year than can be invested properly, especially with Sarbanes-Oxley regulations discouraging smaller companies from going public.” This is not necessarily a problem. Since one exit strategy, an IPO, has become more difficult, the response of the VC industry should be to lengthen their holding period. The implication of fewer companies going public could be that VCs would need to take in additional capital. The imbalance in the flows of capital does not imply a buildup of an excess inventory of capital.

Whether the lengthened holding period will have an adverse impact on VCs depends on how much of their return is due to their investments verses the transactions associated with their portfolio. I have no doubt that IPO bubbles and busts influence whether the portfolio verses the exit strategy yields the greater return. A shakeout, or at least a restructuring of the VC industry, could focus on VCs that are highly dependent on turning over their portfolios.

There is some justification for emphaszing that successful investing in non-public assets requires particular displine in seperating stock and flow decisions. The stock of assets in this asset class that yields the desired portfolio weight, as always, is determined by the total portfolio’s composition. The decision on when to adjust the stock (i.e., initiate a flow) depends on the opportunities available. That too is always the case. What is unique about non-public assets is that both ends of the flow are constrained. For most investors, accessability is a problem on the inflow side, and the very nature of non-public assets is that they are constrained on the outflow side.

The essense of successful investing in non-publis assets is understanding the difference between types of risks. Again, drawing on the discussion of secondary markets for non-public assets, the citation states: “the secondary market takes this de-risking too far. There shouldn't be a guarantee that you can cash out, whether you're an entrepreneur or an investor.” There doesn’t seem to be any basis for assuming reducing liquidity risk actually reduces overall risk. It fact, liquid markets often create their own risk. To appreciate the risk associated with liquidity, one only needs to remember the overheated IPO market.

There are probably many issues associated with non-public assets worth discussing, but the important ones were either covered or implied in one of the postings. So, a disclosure is in order. Specifics are irrelevant since past and current holding are by definition not publicly traded. Suffice it to say, I’ve been lucky enough to have worked for employee-owned companies and acquired other positions through various informal channels. However, like many investors, I've experienced the constraints first hand.

Thursday, April 15, 2010

Angels, entrepreneurs, and diversification: PART 3

Dimensions of risk

Hedging is all about understanding and responding to risk. Thus, it shouldn’t be surprising that a hedged economist isn’t content with the standard one-dimensional definition of risk. Financial economics usually defines risk as price volatility and builds from there. It is a powerful approach, and everyone can benefit from exploring where that assumption leads. PART 2 of the discussion of angels, entrepreneurs, and diversification was built around that approach. Therefore, some caveats are in order before proceeding to a more detailed look at the risk associated with non-publicly traded assets.
As powerful as the approach is, it has limitations. The approach assumes the price series contains all information that is relevant to risk. Let’s recognize two things the approach ignores and then move on. First, the approach ignores the fact that every price series also embodies market participants’ willingness to take risk (i.e., aggregate risk appetite or aggregate risk tolerances). Second, it ignores potential structural sources of risk (the interaction between series). Regarding the second point, it also ignores real or perceived CHANGES in potential structural risk. One can develop an entire theory of panics and bubbles around letting these two overlooked factors interact.
A bigger limitation of the approach is built in. The approach assumes that volatility is knowable and can be measured. When one delves into financial economics, one notices that assuming volatility is knowable creates a situation where further assumptions start flying fast and furious. A good deal of what is interesting in financial economics involves discussion, critique, and the mathematics surrounding volatility. The issue can also introduce all sorts of interesting issues like basic philosophy of science. Most importantly, it opens the discussion to a broader set of risk analysts using analytical techniques other than just financial economics.
Non-publicly traded assets, by definition, don’t have a robust price series. Further, the volatility in what price changes there are is plagued by discontinuities (i.e., big jumps). Consequently, conventional financial economics and investment theory are very limited with respect to what they can reveal. Yet, despite the limitations, conventional financial economics provides a common sense argument for including some non-publicly traded assets.
Less this posting be criticized for overlooking the obvious, let’s acknowledge a point. One can envision applying a variety of approaches to a portfolio of non-publicly traded assets. Any model designed for the analysis of non-continuous situations is a candidate. Survival, hazard, poison, event, and binary models are all types of models that could be used. These are the same types of models used to calculate expected returns on consumer debts, like mortgages. There is a very good case for the argument that they are better at selection than forecasting. However, if that’s your style, have at it. The contention here is that there is a more productive approach.
With that said, back to the issue. The phrase “some non-publicly traded assets” leaves a pretty big range. It almost raises more questions than it answers. So, first let’s look at some risks that are unique, or at least more acute, with non-publicly traded assets.
Let’s start by reviewing some risks that have already been discussed.
First, lack of liquidity is inherent in the fact that they aren’t traded. But, overlooked is the fact that their lack of liquidity means tax planning options are thereby constrained.
Second, accessibility has been mentioned previously. Most people will have access to far too few opportunities that they can consider. That creates tremendous potential for concentration risk.
Third, the lack of pricing data and nature of the volatility of non-publicly traded assets are only the tip of the iceberg when it comes to the scarcity of information. Startups have no history. Further, there is a tremendous potential for information disparities where one party in the transaction has an information advantage. However, the information disparity can exist with any asset.
Fourth, while implied by the lack of liquidity, the risks associated with exit strategy are sufficient to deserve a separate mention. But, people often overlook the associated dilution risk.
While the listing above is far from exhaustive, it is sufficient to introduce the rationale behind another type of risk. Investing in non-publicly traded assets, especially startups, requires a different set of skills from investing in public assets (also different from the skills required to earn a high income). Thus, the argument in PART 2 that financial criteria are irrelevant to the issue of accreditation.
Even without going into the skills required, the point indirectly implies what is probably the greatest risk. Behavioral economists are fond of pointing out that over confidence among investors leads to all sorts of investment mistakes. It is interesting but almost useless information since lack of confidence is another reason for investment mistakes. However, in the case of investing in startups there is reason to believe investors who actual invest in startups may be more prone to overconfidence than investors in general.
The evidence is indirect. But, right off the top, the option of not investing in startups is probably the default of many who lack confidence; it is just so much easier than investing at all. Therefore, there is probably a self selection process that favors the confident.
Second, the characteristics of those who start businesses as the way to access this asset class definitely supports the contention that they are either very confident or have very high risk tolerances. Specifically, as a group, people who start business display an above average willingness to take on concentration risk and leverage risk.
So, while open to debate, pointing out the importance of not being overconfident probably does no harm. Especially in the context of a posting that is a part of an argument that more investors should give startups more consideration and a role in their asset allocation.
Enumerating the risks can only go so far in helping one decide on an asset allocation. Ultimately, it’s a very personal decision based on risk tolerance and the total portfolio. However, generally one can find some empirical evidence to inform the decision. That isn’t easy with respect to startup investing.
The first approach we’ll call the Bogle approach after John Bogle the founder of the Vanguard Group. Bogle advocates cap weight index funds. Vanguard started the first S&P 500 index fund which was quite ground breaking at the time. Currently, Bogle has suggested total market index funds are a better alternative. These are cap weighted funds. So, weights are fluctuating with capitalization. The logic of the funds would be to just let the weighting for non-public assets fluctuate with the portion of the economies total capitalization represented by non-publicly traded businesses.
However, the entire logic of index funds falls apart once one considers non-public assets. First, a major argument for indexing, the low cost, doesn’t translate. Second, indexing involves a default objective. It implies the objective of keeping up with the market. Third, it contradicts another element of the Bogle approach, namely rebalancing. At a minimum it assumes rebalancing within equities is irrelevant.
The Bogle approach isn’t a lot of help. Yet, it does turn up some important leads. The contradiction between rebalancing and indexing across equities highlights the importance of checking for systematic differences between the behaviors of asset classes. PART 2 went though the logical reason for difference in the behavior of traded and non-public assets. Quantitative data is by definition scarce; we’re talking non-public assets. However, there are some potentially similar public asset classes.
The Motley Fools ( recently discussed some research related to the role of small cap stock in a portfolio (see: ). It was such serendipity to come across this while writing this posting that a lengthy quote seems appropriate.
“If there's one guy who should know, it's Ibbotson. He's made a career out of compiling, analyzing, and publishing historical data on the returns of different asset classes. In an interview he did with Barron's back in 2006, Ibbotson maintained that adding small-caps to a portfolio would actually reduce risk -- volatility, in other words -- as long as the total proportion of small-caps to other assets was kept under a reasonable limit, 20% to 25%.
Still skeptical? So was Fool Robert Brokamp, the advisor for the Fool's Rule Your Retirement service. He broke out some sophisticated analytical tools and tested the theory, using the Vanguard 500 Index Fund (VFINX) as a proxy for the blue-chips and a small-cap fund as a proxy for, well, the small caps. And sure enough, a portfolio that was 80% blue chips and 20% small-caps would have had higher returns and less volatility over the past 10 years than just the blue chips alone.”
Some research exists that break out micro caps from small cap. (Please accept my apology I can’t find the reference). It also concludes around 20-25% small AND 5% micro cap. So, publicly traded assets support the belief that small company open new risk frontiers. Now, if non-public assets are even less correlated with large caps than small caps publicly traded companies (as argued in PART 2), the bang for the buck should be even greater. That would imply that the same risk frontier (i.e., risk/return tradeoff) can be achieved with a smaller allocation to non-public assets. Alternatively, the same allocation can achieve a much better risk/return profile. Unfortunately, that’s about as far as that approach takes us.
A different approach is to look at survey results. There is some relevant data. However, the issue is who should be included in the survey. There are quite a few instance where the research design used was to define a target for the survey, and then, to let the reader decide whether the target population is relevant. Most target an audience that is composed of the “rich.” Rich is various defined; then the researcher surveys them about investment behavior. The Federal Reserve’s Survey of Consumer Finance is also relevant. But, all of these sources have what is known as survival bias. If a bunch of non-rich followed the same investment approach, we would never know it just from the research.
Despite the limitations, the survey research is informative. Most of the surveys, in fact every one I’ve seen, show a much larger portion of assets in non-public companies than is characteristic of investors in general. That fact, seems to support the conclusion that more than survival bias is at work.
Figures from 15% to 50% show up depending on what range of asset classes are considered (e.g., owner occupied first residences and non-rental second home, life insurance, pension values, and other assets classes aren’t treated uniformly). Results also vary depending on the level of detail of breakdowns within asset classes (e.g., are startups broken out from other private companies, are other “alternative assets” included, etc). Finally, how the target population is defined is obviously important. But, even with these limitation, the surveys strongly suggest most investors’ portfolios are sub-optimal.

Sunday, April 11, 2010

Angels, entrepreneurs, and diversification: PART 2

Issues of diversification that are overlooked by investors

There is a saying: “Diversification is the only free lunch in investing.” The logic behind the saying is that higher returns are generally associated with greater risk. However, by holding multiple positions, each with some risk, the overall risk is less than the sum of the risks associated with each position. Put simply, something will payoff to offset the losers.

When risk is defined as volatility and return is measured as increase in value, pursuing a strategy of diversifying allows a greater return for a given level of risk. The logic can be formalized, and, presto, you have just learned modern portfolio theory. Formalize it mathematically, envision correlations to measure how much assets move together, reference co-variances to measure how much they move in opposite directions, plot graphs to show the results, call the graphs risk frontiers, and you’ve just written the section on portfolio theory for a text on finance.

The essential concept from an individual’s perspective is that the average risk associated with each individual position can be greater because the risks aren’t additive; some offset each other. The average risk is higher so the average return can be higher without more overall portfolio risk. All well and good, but a few issues have been ignored not the least of which is that risks can be additive without assets that “zig” when other “zag.” In fact, at the market-level they can be multiplicative.

Once one embarks on the quest for the “zigs,” life gets interesting. In the last market cycle, a lot of people learned diversification isn’t JUST holding a lot of categories of assets. Interestingly, if one looks across the last fifteen to twenty years, one finds quite a few years where every publicly traded asset class went down except one. When that happens, the order of magnitude of the drops is reasonably uniform at an annual periodicity. Further, the return on the asset class with a positive return could be fairly characterized as survival rather than profit.

This leaves the individual with a few options. One is to accept more risk (or really, just recognize it was there all along), or adjust to a lower return at the risk originally desired. In modern portfolio theory terms that is called moving to a different risk frontier. But, adjusting one’s risk tolerance (i.e., moving to a different risk frontier) in response to market behavior introduces a new risk. Behavioral economists would argue that most individuals aren’t wired to time such moves in a way that doesn’t itself reduce returns. Broader studies of market behavior confirm the problem. Performance chasing (i.e., people responding to yesterday’s news rather than a forecast of tomorrow) is well documented.

As an alternative, the individual can view time differently. View each couple of years as a window and the number of times the different asset classes move together decreases. That is equivalent to giving up liquidity. Clearly, it is a path the individual can take since they SHOULD know their liquidity requirements.

Like moving between risk frontiers, adjusting liquidity requirements based on market behavior introduces the same risk regarding timing. However, it seems reasonable to hold hope for a more rational individual response since every individual has experience managing cash flow. But, again, aggregate market data isn’t encouraging.

The final option hinges on the phrase “publicly traded asset class.” Another option is to include assets that are not publicly traded. In short, start with a broader definition of assets and all the risk frontiers are different. In fact, every asset class added to the decision process has a very high probability of opening up new frontiers with higher returns at every level of risk. That follows logically since the chance that the new asset varies in value with every other asset is probably zero. However, as mentioned, it isn’t just how many assets are involved. It is how different they are. Since non-publicly traded assets are quite different, the shift in accessible risk/return options is significant. Think of Berkshire Hathaway or some private equity funds if you want examples of instances where this approach has worked.

Interestingly, even though it is logical, it also conforms to the accounting treatment. On the books, one should carry an asset that doesn’t trade at its historical (i.e., acquisition) price. Thus, for what it’s worth, by definition, it isn’t going to vary at all until it trades. That is, unless, of course, there is some event that justifies writing it up or writing it down.

But this posting isn’t just about diversification. It is about how diversification interacts with angel investing and entrepreneurs. So now it is time to introduce angles and entrepreneurs.

Neither angel investments nor startups are publicly traded. One should realize, however, that most new businesses go out of business, fail, or go bankrupt. Exact figures depend on whether going out of business, failing, going bankrupt is being measured, but with any measure the portion is very high.

Each individual opportunity is very risky. For that very reason, opportunities (note the plural) are valuable from a portfolio perspective because they dramatically shift the risk frontier. Put differently, some exposure to potential disasters can allow the rest of the portfolio to be very conservative without changing the overall risk return profile.

Note that taking advantage of this option necessitates overcoming one of the most widely recognized findings of behavioral economic research. Behavior economists argue that most people feel loss more intensely that gain. There is even neurological evidence that the two are felt differently. However, people can train themselves to focus on the total portfolio rather than each individual investment.

The problem with both angel and startup investing is accessibility. For most people such opportunities are rare. Therefore, anything that restricts who has access is forcing some investor onto a lower risk frontier.

So much for the general, now we need to explore the details.

Most of the public is forced to accept a lower risk frontier or resort to informal channels. Formal angel investing is restricted to accredited investors. Following a logic that escapes me, the financial reform package would raise the income and asset requirements for accreditation.

The full proposed financial reform bill can be found at: . This isn’t a link where most readers will find the content interesting. So, for convenience the relevant section is presented below. Unfortunately, even this excerpt references previous legislation. But, hopefully it can stand alone. The basic thrust is clear. It raises thresholds.

The Commission shall, by rule— (1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and (2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.”

The gates to becoming an angel just got harder to enter.

In an interesting wrinkle, the criteria also create some perverse incentives. The criteria focus on income and assets rather than balance sheets and cash flow. Thus, a highly-leveraged investor who already has taken on leverage-risk can qualify for a very risky investment class when another investor with a less leveraged balance sheet could be denied accreditation. The income qualification is also questionable. The appropriate measure isn’t income; it is income after expenses. Angel investing is risky enough. Why create accreditation criteria that could introduce more risk?

In a broader sense, the entire idea that financial criteria should be decisive is ridiculous. Experience, expertise, and specialized knowledge seem more relevant. Probably the most important skill required is the ability to look at and to pass up many opportunities before adding to a portfolio. That just increases the importance of accessibility.

But now let’s focus on the investor who doesn’t have a million or two in assets and a six figure income. Anything that decreases the total number of opportunities is likely to decrease the informal opportunities also. A decrease in the pool of accredited capital could force more startups into the informal channels. That sounds positive for the non-accredited investor: more opportunities. Problem is that the positive would be offset. The total pool of capital hasn’t changed. So, the “reform” would end up forcing otherwise accredited investors to compete for opportunities in the informal channel.

The real impact would be the change that the reform will make in the number of startups. A smaller pool of accredited investors creates increased search cost for entrepreneurs seeking capital. That increases their cost of capital. The cost of capital, in fact, in some cases its availability at almost any price, is an important constraint on the number of startups. By making angel capital less available, the reform will discourage some marginal entrepreneurs. The result will be a net decrease in the number of opportunities.

There is a potentially more serious impact. Early stage investing is risky enough. I suspect the risk will actually be increased by the change in the accreditation criteria when considered in combination with other changes in the regulatory requirements related to angel investing.

The reasons new businesses disappear (regardless of whether by going out of business, failing and going bankrupt) is well documented. Access to capital is the most frequently cited reason by a large margin. The second most frequently cited reason, lack of a business plan, is so closely related to access to capital that in most studies it is hard to figure out which is being measured.

The entrepreneur’s access to capital is a function of how difficult it is for the investor and the entrepreneur to arrange the transfer of capital. Above, the issue of accreditation was discussed from the investor’s perspective. As noted, a smaller pool of accredited investors creates increased search cost for entrepreneurs. It increases the cost of capital for the entrepreneur.

That isn’t the end of it. Section 926 of the financial reform proposal would increase the cost of accessing the smaller pool of accredited investors by imposing new regulatory requirements. Previously, entrepreneurs did not necessarily need to file with the SEC to raise capital from accredited investors. The relevant section is quoted below. My reading is that it increases the regulatory cost directly by requiring a filing. It raises uncertainty regarding the determination of the process. It introduces a delay.

So, the cost of capital has been increased and a new uncertainty has been introduced into an already risky situation. The uncertainties introduced aren’t just whether early stage capital will be available. It is also worth noting that angel investments are not necessarily the first investments. A potential exit vehicle for the self-financed startup or one financed by friends is thrown into doubt. Further, a business that has proven a concept may be stopped dead if additional capital is needed.

Section 18(b)(4) of the Securities Act of 1933 (15 U.S.C. 77r(b)(4)) is amended—(1) by striking ‘‘A security’’ and inserting
‘‘(A) IN GENERAL’’; (2) by redesignating subparagraphs (A) through (D) as clauses (i) through (iv), respectively, and adjusting the margins accordingly; and (3) by striking clause (iv), as so redesignated, and inserting the following: ‘‘(iv) Commission rules or regulations issued under section 4(2), except that the Commission may designate, by rule, a class of securities that it deems not to be covered securities because the offering of such securities is not of sufficient size or scope.’’.
‘‘(B) DESIGNATION OF NON-COVERED SECURITIES.—In making a designation under subparagraph (A)(iv), the Commission shall consider—‘‘(i) the size of the offering; ‘‘(ii) the number of States in which the security is being offered; and ‘‘(iii) the nature of the persons to whom the security is being offered.
‘‘(C) REVIEW OF FILINGS.—‘‘(i) IN GENERAL.—The Commission shall review any filings made relating to any security issued under Commission rules or regulations under section 4(2), other than one designated as a non-covered security under subparagraph (A)(iv), not later than 120 days of the filing with the Commission.
‘‘(ii) FAILURE TO REVIEW WITHIN 120 DAYS.—If the Commission fails to review a filing required under clause (i), the security shall no longer be a covered security, except that—‘‘(I) the failure of the Commission to review a filing shall not result in the loss of status as a covered security if a State securities commissioner (or equivalent State officer) has determined that there has been a good faith and reasonable attempt by the issuer to comply with all applicable terms, conditions, and requirements of the filing; and ‘‘(II) upon review of the filing, the State securities commissioner (or equivalent State officer) determines that any failure to comply with the applicable filing terms, conditions, and requirements are insignificant to the offering as a whole.
‘‘(D) EFFECT ON STATE FILING REQUIREMENTS.— ‘‘(i) IN GENERAL.—Nothing in subparagraph (A)(iv), (B), or (C), shall be construed to prohibit a State from imposing notice filing requirements that are substantially similar to filing requirements required by rule or regulation under section 4(4) that were in effect on September 1,1996.
‘‘(ii) NOTIFICATION.—Not later than 180 days after the date of enactment of the Restoring American Financial Stability Act of 2010, the Commission shall implement procedures, after consultation with the States, to promptly notify States upon completion of review of securities offerings described in subparagraph (A)(iv) by the Commission.’’.

My contention is that the supposed protection for angel investor and those who are now protected from becoming angels is an illusion. They are just protected from one risk while being exposed to another. Further, there is a net increase in the risk associated with new ventures and it has been shifted to the entrepreneur and into the informal investment channel. The situation has been made more risky and that will decrease the total number of opportunities to diversify into this category of assets. Since most investors will consider far too few startup or early stage investments, the result is unfortunate, indeed.

Friday, April 9, 2010

Angels, entrepreneurs, and diversification: PART 1

Entrepreneurs in economics

The entrepreneur plays a crucial role in a healthy economy. That is true in terms of secular growth and especially at turning points. A few months ago, MSNBC ran an amusing story entitled something like ‘The Accidental Entrepreneur.’ It was amusing because it was written as if it was a new thing for people to become self-employed or start a business when unemployment is high.

My reaction to the article was that this would be a slow recovery because there were too few accidental entrepreneurs. At the macroeconomic level, the difference in the rate of recovery in employment as measured by the employer survey verses as measured by the household survey is the best way I know to gain some insight into the phenomenon. It’s a crude measure, but in seems to work. A few months ago the relation seemed anemic; now it seems erratic

The Huffpost Social News recently ran a piece entitled “Proposed 'Protections' for Angel Investors are Unnecessary and Will Hurt America's Job Creators” (see ). It was written by Robert E. Litan of the Kauffman Foundation ( ). The Kauffman foundation is a respected advocate for entrepreneurs.

The point of the piece is quite simple. Anything that discourages the flow of capital to entrepreneurs is counter-productive from the perspectve of job creation. Constraining their access to angel investors does just that.

There are a few points worth adding. First, equity capital is particularly hard for entrepreneurs to access. Thus, angel investors are particularly valuable. The alternatives for many entreprenuers are family, friends, and personal resources. Often this involves draining retirement accounts or literally “betting the ranch” with a big mortgage. The result is increased concentration risk as well as increased leverage risk for the entrepreneur.

Second, equity capital and borrowed capital, like bank loans or SBA-backed funds, have differential economic implications. They are targeted at different risk profiles. Most new businesses don’t succeed. An early stage equity investor doesn’t have to be as conservative as a banker. The equity investor is incorporating a different risk level into a portfolio. Therefore, some looses are consistent with the risk level of equity investors. Thus, they can take positions no bank would. Angel investors are a source of capital for businesses that incorporate risks such as large, early stage R&D expenses Those businesses require someone willing to risk capital in order to exist. High risk ventures will be hurt by the phenomena Litan highlights.

Finally, access to angel investors and early stage equity capital has different impacts on different industries. Although less focused on entrepreneurs, JOB CREATION AND DESTRUCTION by Steven J. Davis, John C. Haltiwanger, and Scott Schub is worth the read. Although dated, the book is under-read. It is worth the time if for no other reason than that the authors look at the issue of churn in employment using employer data.

Unfortunately, it only focuses on manufacturing. That isn’t deadly from the perspective of this last point. The book shows that even within manufacturing the impact of new businesses is different across industries. One would suspect the difference is even greater between manufacturing and other industries. It would seem logical that more capital-intensive industries would have greater barriers to entry if any source of capital is discouraged. It would be an unfortunate unintended consequence of protecting angel investors if it has a particularly negative impact on manufacturing.

Tuesday, April 6, 2010

A disclosure about disclosures

Most tell the reader nothing

Disclosures are supposed to inform the reader. However, they seldom do. Disclosures are included in postings on The Hedged Economist because they can shed light on the reasoning in the posting. As argued on March 30, every financial decision has to be viewed in the context of an individual’s objectives and portfolio. Thus, the emphasis is on explaining a line of reasoning so that the reader can make a judgment. If the disclosures fail to add to the discussion or seem annoying, please let me know. I’d be glad to drop them.

When I was very young, I remember my grandma talking with her sons-in-law about picking a broker. Her rules were simple: She never bought or sold a security because a broker brought it up. If he (they were all men back then) claimed to have good recommendations, she wasn’t impressed. If he talked about what research he’d do for her, she’d listen. Service, especially education, was her criteria.

If a broker recommended a security, her first question was always, “Do you own it?”
It wasn’t a question with a right answer: If not: Why not? Why is it good for me and not for you? If yes: Why didn’t you tell me before you bought it? When did you buy it? How many other people did you already put in it/tell about it? Will you tell me before you get out? Does your company own it?

So, never take a disclosure on these postings as a recommendation. I’m not willing to disclose all the information you would need to assess a recommendation. Further, I can’t know all the personal information about individual readers that I’d need before recommending something for any individual. So, if the disclosures don’t help readers understand my reasoning, let me know.

Monday, April 5, 2010

Gold: Be sure you know what you’ve hedged

Gold and inflation

Of all the things to discuss, gold seems the strangest. So, much has been written from just about every perspective. However, so many people have asked my opinion that a posting seems in order. Rather than take sides in well-hashed debates, two references will point the reader to two lengthy discussions as well as a source for more if needed. The references are followed by some views that might be novel even to one familiar with the issues surrounding gold.

First, one can probably find a variety of opinions at . For example, on March 17th Nick Barisheff started a two part “Primer.” It can be retrieved at . Be aware that his primer is actually an advocacy piece for his position on gold. So, it is worth checking other writer at In the April issue of The Atlantic Magazine , Michael Kingley provides another discussion of the topic. It can be found at . A word of caution to anyone who checks out the articles, read the comments. Some of the comments are as insightful, or even more insightful than the articles.

Before proceeding, there is one comment (made in connection with both articles) that it would be remiss not to repeat. Like everything else, gold and fiat money are subject to supply and demand. Take that a step further by realizing that each potential use for either (e.g., store of wealth, medium of exchange, source of liquidity, method of enumeration or accounting, form of speculation, hedge against various risks, functional value in use, etc.) is also subject to supply and demand. That simple step will put one three steps ahead of most people writing about gold.

The “primer” takes the position that gold is money. The Kingley article discusses gold as a hedge against inflation. The two arguments are often made as if interchangeable. However, they are contradictory both theoretically and historically. They can’t both be valid, and they never have been.

The gold standard, when gold was coined, was associated with some very dramatic periods of inflation for both individual countries and globally. Two well-known examples that have been thoroughly documented are the European inflation after Spain started extracting gold from Latin America and the aftermath of the California gold rush of 1849. There are numerous other less well-known examples. So, historically, gold as money has produced inflation at various times.

People have argued that these historical periods are irrelevant because gold is scarce and new finds are unlikely. Well, quite frankly, if someone wants to increase supply, look to Fort Knox, the NY Fed, and other central banks. Now the individual looking for supply can also look to the stockpiles of the gold ETFs as well. If one wants to depend on governments and commodity speculators for price stability, have at it.

Regarding the theoretical contradiction between the two arguments, anyone who studies how the gold standard was supposed to work knows that inflation in gold surplus areas is essential to the supposedly self-equilibrating characteristic of the theory. Supposedly self-equilibrating, rather than actually, because governments have long since figured out how to “sterilize” (i.e., negate the supposed impact) of gold flows.

That brings up another misconception. People argue that gold, unlike fiat money, is not something governments can tamper with. True, unless they decide to release gold from their stockpiles or to increase their stockpiles. Within recent memory, prices of gold have been held down when European governments reduced their holding and then propped up when China and India recently increased their stockpiles. Further, much of history shows governments pegging gold values in one way or another. Governments clearly are not passive regarding gold, and they never have been.

So, gold is neither a natural form of money nor a natural hedge against inflation. It can play either roll, but only under very specific conditions. So, what does gold actually hedge?

One of the most amusing and telling misconceptions about gold is the lead line on at least one of the current ads for gold. It goes something like this: “Gold is the only asset that isn’t someone else’s liability.” That is supposed to be strength. An asset where there is no counterparty (i.e., no one has promised a return) is better than one where someone promised a return. Go figure! Clearly, gold hedges distrust. The distrust can target government, central banks, bankers in general, or any and every counterparty. It doesn’t matter; it is the distrust that is the issue, not who isn’t trusted.

Further, the statement is just plain wrong. Very broadly-held asset classes, for example, equities, aren’t anyone’s liability. They’re equity. Equity is what is left after liabilities are subtracted from assets. Equities, however, become illiquid, or at least fall in price, during periods of financial or social chaos. Gold can hedge financial and socio-political chaos, but only if the gold isn’t a part of the financial system.

In THE BLACK SWAN: THE IMPACT OF THE HIGHLY IMPROBABLE, Nassim Nicholas Taleb makes the case that extremes are hard (he’d say impossible) to predict. Following his line of argument, the likelihood that they will occur is hard to quantify and consistently underestimated. One doesn’t need to believe he is always right, only that he may be right as it relates to one’s personal ability to always see the future. Concede that error is possible, and it makes sense to have some exposure to gold. Under the circumstances where gold shines, it is too late to start looking for alternatives.

Viewed through this lens, gold is a good hedge against inflation if the inflation is associated with distrust or chaos. It is actually the real or feared chaos and counterparty distrust that gold is hedging. Better yet, that hedge would be valid with or without inflation. However, for inflation that doesn’t result from or spawn extremes, there are alternative hedges against inflation that entail less risk or lower cost. For example, absent the distrust, indexed bonds, TIPS, have a positive return and no storage costs, and absent the financial chaos risk, the stocks of gold miners can effectively hedge inflation risk.

The chaos and distrust argument for gold says nothing about timing unless one adopts the assumption of a perfect ability to forecast chaos and distrust. So, it is a permanent hedge, with the cost usually incurred up front. Gold exposure then becomes like insurance: a pesky necessity for laying-off a specific risk.

So, a not too surprising discloser, for many years I have maintained an exposure to gold. Over the long run, the direct overall expected return is what one would expect from insurance. But, by carefully identifying what risk is being hedged, the actual average return has been better.

Thursday, April 1, 2010

Beware the risk-free return

More silliness on too big to fail (March 5th posting for context) and more on why quants blowup (March 9th posting for context and January 28th and February 28th for some implications).

Sovereign entities are not too big to fail. Default isn’t an absolute. There are a lot of ways sovereign risk can be expressed. Rates are one. The item below touched off a discussion I thought was worth expanding and posting.

“Warren Buffett Safer Than Obama? — By Andy Kroll | Mon Mar. 22, 2010 7:32 AM PDT
Bloomberg News reports today that, according to the bond market, you're safer investing in Warren Buffett than in what used to be the safest of all bets—the US government. The yield on bonds offered by Buffett's storied Berkshire Hathaway last month had a yield that was 3.5 basis points, or 0.035 percent, lower than the US government's Treasury bonds—essentially American debt. Joining Buffett in the safer-than-US-debt category as well were bonds for household names like Proctor and Gamble, Johnson and Johnson, and Lowe's, the home improvement store. "It's a slap upside the head of the government," one financial officer told Bloomberg.
So what's it mean? For one, that the US is selling massive amounts of Treasury bonds—$2.59 trillion since the start of 2009—to borrow money to finance its projects like the stimulus package, bailout, wars in Iraq and Afghanistan, and Obama's other projects. So much money, in fact, that the US will pay 7 percent of revenues to service its debt this year, according to Moody's rating service. According to the Congressional Budget Office, the federal budget proposed by Obama will create record deficits of more than $1 trillion this year and next, and the total deficit between 2011 and 2020 would reach $9.8 trillion, or 5.2 percent of GDP. The US' looming debt crisis is getting so bad and threatening to swallow so much money that Moody's said earlier this month that the US was "substantially" closer to losing its AAA debt rating, the gold standard of bond rating.
From a strictly financial standpoint, the Buffett-Obama comparison highlights just how grim the US' fiscal situation is. It's one thing to borrow deeply to try to create jobs, backstop an ailing housing market, and restart the American economy. But on the morning after the passage of a historic health care bill, the Bloomberg story nonetheless offers a rude awakening as to how deep in debt this country really is.”

I think this exact quote came from . I clicked through to Bloomberg.

Points worth noting are:

First point -- There are ways other than outright default that bond returns can be influenced. That is especially important if the bonds are denominated in other than the bond holder’s native currency. The difference in interest rates between triple ‘A’ corporate bonds and Treasuries may reflect differences portion of each one’s debt that is held by US investors. The portions are probably very different. Consequently, rate differences could reflect differences in the importance of currency bets.

The example cited above is also interesting because the notes mentioned are 2 year notes. The article doesn’t mention the rest of the yield curve. Two year Treasuries are partially driven by liquidity issues, while corporate bond buyers are more likely to intend to hold to maturity. That’s what makes this phenomenon so curious: investments that aren’t as liquid are getting a better interest rate than a more liquid issue. Weird enough to make one suspicious that it also involves perceived downgrade concerns.

There is another interpretation. It could be that the rate differences reflect volatility risk with or without downgrade risk. If traders expect rate volatility while buy-and-hold investors don’t care, then the same things that make Treasuries attractive to traders (i.e., the volume of trading in the secondary markets) would work against them here. (By the way, I know this assumes some non-maximizing behavior on the part of buy-and-hold investors. But, on a two year note, I don’t think it’s an unreasonable hypothesis. But, if that was the entire story, one would think it would be arbitraged away).

It would thus seem that the investor cited in the Bloomberg story is at least partly right. It is probably an expression of differences in the market’s assessment of downgrade-risk. It is unusual for a company in a country to have a rating higher than the country, but not unheard of. I’d also be surprised if there wasn’t an element of currency risk at work also.

Second point -- Governments can change the rules in many ways that influence the return on their bonds other than just by defaulting. Those changes may or may not have an impact on corporate bonds. Governments have used currency controls and currency manipulation, restrictions on capital flows, changing the form of repayment (think gold denominated US bonds in 1933, but the more common form in other countries is changing foreign denominated bonds to local currency at some government-pegged exchange rate).

In fact, some people believe the changes that were made in how inflation is measured are an example of the government intentionally manipulating the payout on TIPS. The government also controls the tax treatment of interest and principal repayment on their debt. Right now the Fed is manipulating the entire yield curve by buying Treasuries. They are manipulating interest rate risk in bond investor terms.

When Bill Gross said sovereign debt now has to be considered more competitive with corporate triple 'A' debt, I don't think he was kidding. This is an example. This example may go away, but I don't think this will be the last time it shows up. It is also quite likely it won’t always be this obvious.

One other aspect of sovereign risk is worth noting although it is not directly relevant to the quote about triple ‘A’ verses Treasuries. Governments have off balance sheet liabilities that make ENRON look like a piker. Defaulting on explicit or implicit guarantees or commitments is a very convenient way for governments to default.

Add in inflation risk and interest rate risk and it doesn’t take a genius to see that a risk-free rate of return is a myth.

Third point -- This one gets away from sovereign risk directly, but relates to the concept of a risk-free rate of return. If one were thinking about a long-short arbitrage trade, there may be a currency issue involved since, as argued above, currency expectations will have a different impact on the two legs of the trade. So, even if one thinks there is no chance of a downgrade, it isn’t a risk-free trade.

This example illustrates an important general point. One only needs an active imagination to generate feasible scenarios that highlight subtle, and sometimes not so subtle, risks embedded in many situations that look like easy arbitrage opportunities. Truly risk-free trades are extremely rare.

Einstein referred to “thought experiments.” These might be considered thought scenarios. It is an amazingly constructive form of daydreaming. Just think up the scenarios and start assigning probabilities to any scenario that will cause the trade to backfire. Next step is to figure a way to hedge away that risk, then repeat the thought scenario exercise. Each hedge introduces new risks that have to be put through the same process. Just in terms of the Treasury to triple ‘A’ example, the currency risk could be any individual currency or a weighted basket where the weights reflect the portions of the debt held by different countries.

A few iterations and a little thought about the costs of the hedges and, bingo, you’ve just backed into an understanding of why quant funds blowup. Imagine backing up these thought scenario exercises with massive databases and computers in order to identify the trades, flag the hedges, quantify the probabilities, and quantify the appropriate size (i.e., cost) of each hedge. Let’s assume all hedges have been correctly identified, the required sizes calculated correctly, probabilities correctly assigned, etc. After all, the quants have the computers, lots of brain power, and data out the whazoo. We’re just daydreaming. They might actually get it right.

But, daydreams of perfect risk-free trades should make one thing clear. They are likely to have multiple “legs” which will increase the cost. It quickly becomes apparent that the margins per “dollar in play” are going to be small. Thus, bigger plays with more leverage are required to justify the effort. So, now in addition to the market risk associated with the trades, the “risk-free” trading system has assumed tremendous leverage risk. Once the issue of leverage is introduced, even with perfect management of the leverage, there is no stable level of leverage at the aggregate level.

The discussion above made the unrealistic assumption that it would be possible to construct the perfect trade. But, much of the intellectual underpinning of modern financial economics has a risk-free cost of capital assumption built in. The first two points should have torpedoed that assumption. So, anyway one looks at it, a risk-free return is a happy fiction. When built into a trading strategy, explicitly or implicitly, it is dangerous.

The issues discussed above are illustrative of a broader issue. The concept of a risk-free rate of return is like a cancer that has invaded modern financial economic theory. Usually, Treasuries Bills are used as a quantitative expression of the mythical risk-free rate of return. Every time “risk-free” appears in a formula or in print, stop! Ask: “What does the author really mean? Are they really saying anything? What concept really should be used? What assumptions have to be made in order for the formula or phrase to make sense?” All sorts of issues get brushed aside through the simple assumption that risk-free returns are an acceptable substitute for addressing some very volatile behaviors.

Finally, some disclosures are in order. I own corporate bonds, but not Berkshires. I have puts on some Treasuries, but not two years. I also own TIPS. The puts are a trade that I am close to closing out. The bond positions are more problematic. Without the puts, I’ll have taken on interest rate risk that I may want to shed.