The rapid growth of ETFs is one of the most significant changes to financial markets in the last decade. Total ETF AUM grew from $0.5 trillion in 2008 to over $3 trillion by the end of 2017. More remarkably, AUM of ETFs invested in illiquid sectors such as global bank loan , emerging market bonds, and global high yield bonds increased 14 fold from $10 billion 2007 to $140 billion at the end of 2017. Prior to the last financial crisis, ETFs were a relatively small niche, but these past few years it seems like every asset manager has launched an ETF. Most investors have a large portion of their retirement assets in ETFs, and many investors exclusively invest in ETFs.
This is a major systemic change from what was in place prior to the last financial crisis. Since markets go through cycles its worth asking: how will the ETF ecosystem hold up next time there is market turmoil?
ETFs have overall been a massive benefit to investors because they lowered costs. Yet as more and investors put more and more money into ETFs, there are growing signs of distortions. Some investors have pointed out how ETFs are creating bizarre valuations that are unlikely to be sustainable. Additionally, there are growing signs that the ETF structure is far more fragile than most market participants realize. These aren’t just doom and gloom conspiracies from Zero Hedge. Organizations such as the IMF, DTCC, G20 Financial Stability Board, and the Congressional Research Service have all pointed out possible risks from the unintended consequences of ETF growth.
How the ETF ecosystem works
The structure and mechanics of ETFs are unique and different from mutual funds. Unlike mutual funds, ETFs generally don’t have to meet redemptions in cash. The key difference is the role of Authorized Participants (APs), and the arbitrage mechanism. The Congressional Research Service provides a handy diagram explaining the structure (Most fund sponsors have similar diagrams in their whitepapers) :
From the same CRS paper:
In a typical ETF creation process, the ETF sponsor would first publish a list of securities in an ETF share basket. The APs have the option to assemble and deliver the securities basket to the ETF sponsor. Once the sponsor receives the basket of securities, it would deliver new ETF shares to the AP. The AP could then sell the ETF shares on a stock exchange to all investors. The redemption process is in reverse, with the APs transferring ETF shares to sponsors and receiving securities.
ETF shares are created and redeemed by authorized participants in the primary market. The fund sponsors do not sell their ETF shares directly to investors; instead, they issue the shares to APs in large blocks called “creation units” that usually consist of 50,000 or more shares. The APs’ creation and redemption process often involves the purchase of the created units “in-kind” rather than in cash. This means that the shares are exchanged for a basket of securities instead of cash settlements.
The supply of ETF shares is flexible, meaning that the shares can be created or redeemed to offset changes in demand; however, only authorized participants can create or redeem ETF shares from the sponsors. A large ETF may have dozens of APs, whereas smaller ETFs could use fewer of them.
The “arbitrage mechanism” is a key feature of the ETF ecoystem. The market incentivizes APs to correct supply demand imbalances for ETFs because they can always exchange underlying shares for the securities in the portfolio and vice versa. So theoretically ETFs should not end up with discounts or premiums to NAVs like closed end funds.
Additionally, since the ETF Sponsor can redeem in kind, rather than in cash, they don’t need to sell underlying securities to meet redemption requests, like with mutual funds. Additionally, unlike with mutual funds, you get some intraday price transparency. Sometimes media commentary on “illiquid assets in liquid wrappers” mixes these up, but the nuance is important to how the respective ecosystems will react to market turmoil.
The arbitrage mechanism is a huge benefit for ETFs, and it works pretty well for deep liquid markets, like large cap stocks. Yet with less liquid assets such as leveraged loans or high yield bonds, there is reason to worry. ETFs haven’t really solved the liquidity mismatch problem. Closely related, any understanding of market history leads us to conclude that APs are unlikely to function in a falling market.
Liquidity mismatch in ETFs
Theoretically if there is a flood of selling at ETF level, APs can buy from portfolio managers, then exchange for underlying securities. However what happens if there is no bid/ask for some or all of the underlying securities?
There are several large ETFs that consist of leveraged loans and high yield bonds. A retail investor can have instant liquidity in the ETF market, and theoretically if there is an imbalance in the secondary market APs will step in and exchange ETF shares for the underlying bonds and loans. Yet these underlying assets can go days without actually trading(they are “trade by appointment”) . ETFs may be a small percentage of all outstanding bonds/loans, yet there is very little turnover of these assets, and often its difficult to get pricing. Its not clear how the market would respond if there was a macro event that caused loan prices to gap down, and investors to seek redemptions from ETFs en masse. Prior to the last financial crisis, few ETFs held high yield bonds, and no ETFs held leveraged loans.
According to the DTCC:
Some analysts assert that ETFs have become so large in certain markets that the underlying securities may no longer be sufficiently liquid to facilitate ETF creation/redemption activity during periods of stress and could result in price dislocations.
From Duke Law’s FinReg Blog:
Consider a crisis scenario where selling pressure causes underlying assets (like fixed income securities) to become illiquid and rapidly lose value prompting ETF holders to quickly sell their shares. Here market makers and APs would likely widen their bid-ask spreads to “compensate for market volatility and pricing errors.” Increased fund redemptions in the primary market could also detrimentally change the composition of the underlying portfolio basket causing APs – who no longer want to redeem ETF shares and receive, in-kind, the plummeting and illiquid securities – to withdraw from the market altogether.
Also notable, post financial crisis regulatory changes caused bond dealers to hold less inventory. This can mean less liquidity in a crisis, as this recent academic paper notes:
When an extreme crisis hits, historically, OTC market liquidity disappears. That is, no one is available to take the other side of the trade. There are simply no bids, no offers, and no trading activity in OTC markets. The recent reduction in dealer inventories means that markets will be even more volatile in the next crisis.
This is unlikely to be a problem for deep liquid markets such as large cap stocks. So any problem with popular stock index funds is likely to be resolve itself quickly But it could take a long time to unwind problems in leveraged loan and high yield bond ETFs.
Won’t the APs fix this?
Its important to emphasize that the APs have no fiduciary duty to provide liquidity. The AP will have an agreement with the fund sponsor, but the fund sponsor does not compensate the AP directly. APs can profit by acting as dealers in the secondary market, or clearing brokers, thus collecting payment for processing and creation/redemption of ETF shares from a wide variety of market participants. APs can stop providing liquidity anytime they want. In the event of a crisis it may be prudent to do so. From Duke Law:
As such, a reliance on discretionary liquidity, in the context of a crisis is inherently “fragile” since dealers and market makers will stop providing it once they start incurring losses, or their balance sheets are negatively impacted from other exposures and they can no longer bear the additional risk from providing the liquidity support
In 2013 some ETFs traded at a steep discount when Citigroup hit its internal risk limits. That was in the middle of a great bull market. What will happen if there is a serious macro problem? As a historical precedent, during the financial crisis the auction rate security market collapsed when discretionary liquidity providers exited due to turmoil.
A different kind of death spiral
There are risks for both ETFs and Mutual Funds that hold illiquid assets. However the reasons are different, and the nuances of a blow up will be different.
A mutual fund can get exemptive relief from the SEC to suspend cash redemptions in extreme circumstances. Mutual fund investors, who thought they had a daily liquidity vehicle, are left holding an illiquid asset. This happened to the Third Avenue Focused Credit fund a couple years back. This caused a short lived mini-panic in the high yield debt market. When the fund suspended cash redemptions, they paid redemptions in shares of a liquidating trust. An outside party offered to buy the shares at a 61% discount to the NAV, which had already declined sharply.
In the case of an ETF it’s a bit more complicated. The death spiral could simply take the form of a self reinforcing feedback loop. Retail investors would be able to exit, albeit at a steep discount. APs would sell underlying securities that they can sell, causing prices to plummet, causing further retail panic. Some assets are more illiquid than others, and once once the dust settles, the ETF will be left holding the most illiquid and opaque assets.
During the past few years we’ve seen a few tremors. There was the short incident in 2013 mentioned above. In May 2010 and August 2015 there were large one day price swings in more liquid parts of the ETF market probably caused by algorithms. In February 2018 there was the great VIX blowup/ “volmageddon”. The VIX example was a bit different because it involved very unique derivatives, but I think the bigger more interesting problems could be in the credit space. In 2018Q4 there was some volatility in the credit space, and MSCI noted ETFs appeared to have a mild impact on bid/ask spreads. Yet by historical standards what happened in 2018Q4 was very minor.
These examples all occurred during a long bull market. What will happen in the next 2008 type scenario? I Still need to look more into how they might actually unwind.
So what can an investor do?
Most ETFs(and mutual funds) will probably be fine. During a crisis there might be temporary NAV discounts even for large cap index funds and lots of panic selling all around. Mutual fund investors will redeem at the worst possible time, and funds will sell shares into a falling market to meet these requests. Headlines will be full of doom and gloom. The prudent thing for most investors will be to ignore it all. Continue dollar cost averaging across the decades to retirement and beyond.
Nonetheless, investors holding some of the more esoteric, illiquid ETFs and mutual funds could be in for an unpleasant surprise and possible permanent capital impairment. Even though these potentially problematic funds are a small portion of the overall market, there is likely to be systemic contagion, as the IMF noted.
I’ve purchased some cheap puts on more fragile ETFs(mainly high yield bond and leveraged loan) although the lack of an imminent catalyst means that the position size needs to be small. I’ll be looking more closely at the way these different types of structures are unwound, since there are likely to be some major time sensitive opportunities next time it occurs.
Other possible case studies of the unwinding of illiquid assets in liquid wrappers:
- UK open end commercial property funds during Brexit vote
- Auction rate securities during financial crisis
- Interval Funds during the financial crisis.
- Other mutual fund redemption suspensions and ETF tremors?
The Ruthless, Secretive and Sometimes Seedy World of Hedge Fund Private Investigations Highly entertaining expose.
Listening to Barakett talk about some of his wildest cases gives some idea of how easy it is for people to fall through the cracks during cursory due diligence. For example, on its website, DDC says it once found that “the president of a large U.S. asset manager was arrested twice for major art theft” but was never charged due to the expiration of the statute of limitations.
The art theft case was a “thing of beauty,” Barakett recalls. The manager, who still runs $2 billion, was even discovered to have one of the stolen paintings in his office when a police investigator went to interview him regarding the second theft. (The man was in college at the time of the thefts, which were from the university.) DDC’s client, a family office considering making a big investment, “could not believe what we were telling them,” Barakett says. It decided to walk away.
Another case involved a Bear Stearns executive whose murder conviction had previously gone undetected because, Barakett suspects, a casual background check either did not look at records in every state he had lived in or checked the wrong name or date of birth. “Our client [an asset manager who was considering hiring the man for an IR position] could not believe it, and we showed him the proof,” he recalls.
Vanguard Patented a Way to Avoid Taxes on Mutual Funds Interesting implications for tax policy, fund structuring and intellectual property strategy.
Vanguard has discussed licensing its hybrid ETF-mutual fund design to other firms, but no deal has come to fruition, according to people with knowledge of the talks. Those that have expressed interest included both index followers and active stock-pickers. United Services Automobile Association licensed the patent but never used it, and Van Eck Associates Corp. once sought regulatory approval for a similar design. Spokesmen for USAA and Van Eck declined to comment
Biglari Holdings is the Fyre Festival of Capitalism Hilarious because I’m not a shareholder in this company.
Many managements probably revile their shareholders, but most of them do not publicly delight in doing so. Sardar Biglari and Phil Cooley, Chairman and Vice Chairman of Biglari Holdings, seem to delight in the annoyance of its shareholders. At one point laughing at them for being upset that the share price went down 58% last year and then subsequently watching the board increase Sardar’s compensation package. It is not my best-self that enjoyed this spectacle, it was more like the part of me that likes watching dragons fight dragons on Game of Thrones that was riveted by Sardar Biglari and Phil Cooley or the part of me that once saw two clowns get into a fist fight at a kid’s party in St. Petersburg and rather enjoyed it.
Buspirone Shortage in Healthcaristan SSR Close look at weird incentives and unintended consequences of regulation in the generic drugs market.
You get more of what you subsidize and less of what you tax. Unfortunately, the FDA is inadvertently taxing companies for being in the generic drug business. And it’s taxing them more if they’re not a monopolist with economies of scale. That means we get fewer companies in the generics industry, and more monopolists.
So my very tentative guess as to why buspirone is more plagued by shortages than bread or chairs is because number one, the need for FDA approval makes it hard for new companies to enter the buspirone industry, and number two, the FDA’s fee structure favors large-scale monopolies over small-scale competitors.
Why So Many Investors Missed Nike’s Stock Rebound Good case study
Legendary stock-picker Peter Lynch’s maxim to “buy what you know” has long been misconstrued to mean invest in the everyday products you consume. That’s not quite right, as it only reflects part of his investment strategy. The other half is buying what you have a unique insight into that the market has yet to figure out. Knowing what those things are is the hard part.
Artko Capital 2019Q1 Letter Interesting commentary around position sizing.
This is where the “Valeant problem” that is rarely discussed, becomes an issue for us: what to do with a position that rapidly increases in size relative to the rest of the portfolio and where Hahn Capital Management and Sequoia/Value Act approaches to the matter differed. While the latter funds continued to hold, and allowed the single position to become almost a third of their portfolio, Hahn Capital had strict risk controls and processes in places that forced them to sell down the position to at least 4% of the portfolio when it became 6% of the portfolio’s weight. Luckily for Hahn, they exited the position prior to the spectacular blow up while the other aforementioned funds suffered significant double-digit portfolio losses when the truth about Valeant’s practices became public. Of course that is not to take away from the spectacular track records of all of the aforementioned funds, but to point out how different investment strategies (concentrated versus diversified), portfolio manager incentives (Management Fee Only versus Performance Carried Interest), and risk control processes (on single position sizes) can result in very different portfolio returns and risk profiles for different shareholders of the same stock. To put another way, sometimes a sell decision is not one of security analysis but one of portfolio risk management and fund strategies. As a result of this, and other similar experiences throughout our career, we have tried to approach the middle ground of the two styles by having a strong degree of concentration and conviction in our portfolio while still maintaining a robust portfolio risk management process focusing on capital preservation, position size, and its risk-reward ratio relative to the rest of the portfolio.
Additionally, we believe the other lesson to be learned from Valeant was no matter how high of a conviction, knowledge base or confidence you have in a publicly traded company or its management, at the end of the day things can and occasionally do go unpredictably wrong and are out of your control. This is a staple of public equities investing and is a common mistake made by even the most reputable investors: having the illusion of control.
An Ancient Relationship: FinTech and Financial Advice Classic look at an ancient profession. Interesting how the stock ticker seemed to have an impact almost as large as the internet.
How has this profession lasted so long? The industry’s longevity is largely attributable to financial technology (FinTech), which has historically empowered advisers to better serve their clients. Many companies, for example, offer advisers quantitative and accurate measurement of investors’ risk tolerance. Equipped with this technology, advisers have a better sense of how clients will respond to volatility, and can construct portfolios that most accurately reflect a client’s ability to endure market swings.
The ticker technology served as a means for democratizing access to market information. Prior to its invention, only those physically present at the stock exchange – or very close by – were privy to real-time market prices. Everyone else received their data at a substantial lag, often to the point where it was no longer useful. Once the ticker was released, however, cables and telegraphs connected brokers across the country to a network of data constantly flowing from a central source, the New York Stock Exchange. According to Horace Hotchkiss, 23,000 offices paid for ticker services in the United States
In Defense of Complexity Most people are knee jerk advocates of simplicity, but forget what lies beneath.
But simple is impossible without complex. Simple is how you interact with your web browser or an app on your phone. Complex is everything else happening in the background that allows it to function.
There are some valuable and diversifying asset classes that routinely get discarded to the “Too Complex” pile for reasons related to ambiguous classification, unfamiliar tools, novel wrappers and peer/career risk. Which is unfortunate, because I would argue that certain alternative investments are complex in implementation only. Conceptually, they are often quite simple, intuitive, backed by data and grounded in economic theory. The arc of the investable universe is long, and it bends towards democratization and innovation. Not every shiny new toy deserves a spot in your portfolio, but it would be wise to reconsider exactly what constitutes simplicity in investing.
Geopolitics and History
You read in every textbook that cliché: Power corrupts. In my opinion, I’ve learned that power does not always corrupt. Power can cleanse. When you’re climbing to get power, you have to use whatever methods are necessary, and you have to conceal your aims. Because if people knew your aims, it might make them not want to give you power. Prime example: the southern senators who raised Lyndon Johnson up in the Senate. They did that because he had made them believe that he felt the same way they did about black people and segregation. But then when you get power, you can do what you want. So power reveals. Do I want people to know that? Yes.
There’s always something the other guy doesn’t want to tell you, and the longer the conversation goes, the easier it is to figure that out
The one thing we haven’t had mercifully over the last 60 year except for the breakdown of Yugoslavia, and Iraq and so on is a major confrontation between big powers wanting to escalate.
While there is a long and lamentable history of science — physics in particular — being hijacked for mystical and New Age ideologies, two things make Jung and Pauli’s collaboration notable. First, the analogies between physics and alchemical symbolism were drawn not only by a serious scientist, but by one who would soon receive the Nobel Prize in Physics. Second, the warping of science into pseudoscience and mysticism tends to happen when scientific principles are transposed onto nonscientific domains with a false direct equivalence. Pauli, by contrast, was deliberate in staying at the level of analogy — that is, of conceptual parallels furnishing metaphors for abstract thought that can advance ideas in each of the two disciplines, but with very different concrete application.
Philosophy is, in part, kept alive by ever-changing sociocultural circumstances that demand new lived responses to its question. But the changes brought by the digital age are of a magnitude beyond the routine vicissitudes of history. The global distribution of knowledge is arming, perhaps overloading us with more information than ever before, and the proliferation of digital interfaces is reprogramming how we experience life itself, our attentive and perceptual faculties.
…What I’m getting at is the possibility that the basic human conundrum is no longer driven by a deficiency in discovery, but in design. That now more than ever, we’re equipped with the information needed to live well, but aren’t integrating that information into our daily routines, our lived realities. There’s a lag between what we’re discovering and how we’re living.
The flood of information made available through the internet filled the discovery container with more than it can hold. We’re spilling things, getting the fabric of human life all wet. These moments of imbalance are when priority shifts from discovery to design. At these points, the work falls upon those positioned between the two containers, using what we’ve discovered to imagine and implement new designs, to convert influxes of knowledge into wisdom that can be embedded into the internal logic of our ecologies, enriching the relational environments from which our sense of being is woven.
In other words, the singularity got cancelled because we no longer have a surefire way to convert money into researchers. The old way was more money = more food = more population = more researchers. The new way is just more money = send more people to college, and screw all that.
But AI potentially offers a way to convert money into researchers. Money = build more AIs = more research.
If this were true, then once AI comes around – even if it isn’t much smarter than humans – then as long as the computational power you can invest into researching a given field increases with the amount of money you have, hyperbolic growth is back on. Faster growth rates means more money means more AIs researching new technology means even faster growth rates, and so on to infinity.
Presumably you would eventually hit some other bottleneck, but things could get very strange before that happens
A recurring motif in Capital Returns: Investing Through the Capital Cycle, by Edward Chancellor is that growth vs. value is a false dichotomy:
Our belief is that stocks should be viewed not as “growth” or “value” opportunities, but rather from the perspective of whether the market is efficiently valuing their future earning prospects.
Marathon’s approach is to look for investment opportunities among both value and growth stocks, as conventionally defined. They come about because the market frequently mistakes the pace at which profitability reverts to the mean. For a “value” stock, the bet is that profits will rebound more quickly than is expected and for a “growth stock,” that profits will remain elevated for longer than market expectations.
Marathon looks to invest in two phases of an industry’s capital cycle. From what is misleadingly labelled the “growth” universe, we search for businesses whose high returns are believed to be more sustainable than most investors expect. Here, the good company manages to resist becoming a mediocre one.From the low return, or “value” universe, our aim is to find companies whose improvement potential is generally underestimated. In both cases, the rate at which a company reverts to mediocrity (or “fade rate”) is often miscalculated by stock market participants. Marathon’s own experience suggests that the resultant mispricing is often systematic for behavioural reasons.
Labelling fund managers as “value” or “growth investors risks distorting the investment process
Warren Buffett discussed a similar idea in Berkshire Hathaway’s 1997 Shareholder letter:
…most analysts feel they must choose between two approaches customarily thought to be in opposition: “value” and “growth.” Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross- dressing.
We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago). In our opinion, the two approaches are joined at the hip: Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
In addition, we think the very term “value investing” is redundant. What is “investing” if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).
Whether appropriate or not, the term “value investing” is widely used. Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield. Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments. Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.
Similarly, business growth, per se, tells us little about value. It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions. But such an effect is far from certain….
…Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value. In the case of a low-return business requiring incremental funds, growth hurts the investor.
Berkshire Hathaway’s 1997 Shareholder letter
False dichotomy, but useful heuristic
Growth vs. value is a false dichotomy, but it might be a useful heuristic for organizing a portfolio. With a “value” investment, you are buying assets, and betting on a reversion to the mean. Generally this means other people are overestimating the bleakness of the future. With a “growth” investment you are buying the future business, betting on change. Generally this means other people are underestimating the brightness of the future.
The key is having an intellectually honest variant view.
Venture capital and value investing
In a similar vein, its easy to see how venture capital and value investing are actually quite similar. Both are mispriced bets on the probability of change.
Tren Griffin wrote about this:
Venture capital and value investing share many different elements but each system is based on a different mispricing. This is a critically important point for an investor to understand. If an asset is not mispriced, market outperformance is not mathematically possible. It is also important to understand that investments can be mispriced for different reasons.
In venture capital the mispricing occurs because very few investors or asset owners understand optionality. This allows a VC to buy what are essentially long-dated, deeply-out-of-the-money call options from companies at prices which are a bargain.
In value investing the mispricing occurs because the market is bipolar (i.e., neither always rational nor always efficient). This allows an investor to sometimes buy assets at a price which reflects a discount to intrinsic value (i.e., a bargain) and to wait for a good result rather than trying to “time” the market.The fundamental difference between venture capital and value investing
Marc Andreessen, in an interview with Tim Ferriss, expressed a similar idea, noting how much he studies and admires Warren Buffett:
Business Lessons From Marc Andreeseen
… every time I hear a story like See’s Candies, I want to go find the new scientific superfood candy company that’s going to blow them right out of the water. We’re wired completely opposite in that sense. Basically, he’s betting against change. We’re betting for change. When he makes a mistake, it’s because something changes that he didn’t expect. When we make a mistake, it’s because something doesn’t change that we thought would. We could not be more different in that way. But what both schools have in common is an orientation toward, I would say, original thinking in really being able to view things as they are as opposed to what everybody says about them, or the way they’re believed to be.”
A decent portfolio has a combination of mean reversion bets, and underpriced deep out of the money options. It pays to be an intellectual cross dresser
In the past I have been a knee jerk advocate of disintermediation. However upon closer examination I realized that the reality of middlemen is far more nuanced. Many people believe that modern technology is eliminating middleman, yet in fact their role is changing shape, not disappearing. In the Middleman Economy , Marina Krakovsky examines this aspect of the modern economy. The Private Investment Brief has also produced valuable analyses of middleman business models. Additionally, Michael Munger’s paper puts this all into a historical context with emphasis on the importance of reduced transaction costs.
Conventional wisdom says that middleman take a cut of every deal, so they raise buyer costs and reduce seller profits. In reality by facilitating transactions that would otherwise not happen at all, good middlemen enlarge the size of the pie, making all parties better off. Many people assume that middlemen’s work is easy because they don’t actually create anything. But to create value… good middlemen must cultivate distinct skills and practices, which they deploy in work that until now has been largely hidden from public view…
“Instead of the of the demise of the middlemen, we are seeing the rise of the middleman. In fact , ours is more than ever a middleman economy.”
Marina Krakovsky, Middleman Economy
There seems to be a gap between public perception and market reality. Therein lies the opportunity:
And yet—thousands of years after it first occurred to someone to ask “why don’t they just cut out the middleman?”—middlemen continue to exist and even thrive. Therein lies the opportunity, for if we can learn to appreciate what others dismiss or misunderstand, we might then have an investing green field all to ourselves
-Mystery of the Middleman
Indeed, Michael Munger takes it even further and argues that we are experiencing a profound historical shift that will alter capital allocation incentives across the economy:
The Neolithic revolution made it possible for humans to enter complex relations of more or less voluntary dependence, and to share economies of organization and information. The Industrial revolution created an astonishing burst of productivity, which made ownership ofMichael Munger: The Third Entrepreneurial Revolution: A Middleman Economy
a bewildering variety of commodities and tools possible for all but the poorest of people, where just 50 years before such items would have denied all but wealthiest. The Middleman revolution, the third revolution whose leading edges we are now crossing, will transform owning
into sharing. The Middleman revolution will make it possible, for the first time, for entrepreneurs to create value almost exclusively by reducing the transactions costs of sharing existing commodities, or by sharing commodities or services made expressly to be shared by the new platforms and new market processes.
Aggregators by any other name
In a world where buyers and sellers can just find each other online quickly and easily, middleman must be obsolete, right?
Wait a minute…
Often when people talk about cutting out the middleman, they are actually just replacing it with a new middleman. All the aggregator platforms are in fact distinct breeds of middlemen whose businesses are made possible by the internet. Examples include: Airbnb, Lyft and Uber, Taskrabbit, Grubhub, ZocDoc, etc. Instead of a person, buyers and sellers deal with software on a website that is developed and managed by people. As Krakovsky points out:
In many ways, the internet is a middleman’s ally. Thanks to the internet, middlemen who used to do business in person — a position that limited their geographic reach can a attract customers from all over and can share information with them more quickly and easier than ever…
These days, two sided markets (sometimes called two-sided networks or two sided platforms ) are everywhere because many of today’s internet startups are middlemen business of exactly this type
Understanding middleman requires multidisciplinary thinking. There isn’t really one accepted definition, and there are many different angles from which to analyze how this social and economic phenomenon works:
Economic theory has much to say about transaction-cost economics, two sided markets, and intermediaries ability to reduce information asymmetries between buyers and sellers. In particular, game theory informs our understanding of repeated interactions, reputation, shirking and cheating, and third party enforcement. Social psychology and experimental economics show how acting on behalf of others affect people’s behavior and impressions. And sociology offers insights into the way acting on behalf of others affects people’s behavior and impressions. And sociology offers insights into the ways the structures of social networks create opportunities for middlemen
Six kinds of Middlemen
Krakovsky identifies five different roles that middleman can play. These roles define what middleman’s trading partners expect, so its critical for a middleman to know what role they play, and do play it well. They often overlap, so a successful business may fill of these roles at different times in the same supply chain.
A bridge promotes trade by reducing distance(either physical, social or temporal). RA Radford’s study on the development of a market in a WWII POW camp is a stark example. An itinerant priest was willing to connect disparate groups who did not interact, facilitating trade along the way.
Another example featured in the New York Times and highlighted by Private Investment Brief involves an Afghanistan based used clothing wholesaler who makes an annual trip to Pakistan to buy bulk clothing. He is able to succeed for many reason, one of which is the fact that he reduces the fixed costs of dealing with travel, customs, logistics, etc.
A certifier gives reassurance about underlying quality. This is important anywhere there is need for a trusted third party. Essentially, they help fix information asymmetry in a market. That same clothing wholesaler who facilitated trade between Pakistan and Afghanistan was also known as a trusted counter party to disparate group of buyers and sellers.
Trust is an elusive and intangible quality, so those of us in the more contemplative, analytical corners of the business world tend to underestimate how important it is to people transacting day to day
Mystery of Middlemen
An enforcer makes buyers and sellers cooperate and stay honest. Like certifiers, they are important in situations where there is need for a trusted third party. My favorite example of an enforcer is the role of a pimp at a truck stop in Uganda.
A risk bearer reduces fluctuations. Micro VCs play this role, especially now that technology has drastically reduced the cost of starting businesses. “Uber for this or that” business models are an example of a risk bearer business model. Additionally in the Japanese fish markets, risk bearing middleman ensure smooth functioning of trade in a highly perishable commodity.
A concierge reduces hassles and helps clients deal with information overload. For example, travel agents, in spite of widespread predictions of their demise, play a critical role in high end business travel as concierge middlemen.
An insulator helps clients get what they want without being though of as too greedy, self promotional, or confrontational. Sports agents help defuse tensions between players and teams. Additionally, sometimes an investor will use a broker to build up a position without signalling the market. This may be essential in distressed and illiquid securities, or disputed situations.
Munger looks at markets in the broad sweep of history. The role of technology, he argues, is in creating a new “entrepreneurial revolution” that makes middleman more important in an an economy based on sharing, not owning.
The third entrepreneurial revolution will be based on innovations that reduce transactions costs, not the costs of the products themselves. An unimaginable number and variety of transactions will be made possible by software platforms that make renting from a middleman, rather than renting from one’s self, cheaper.
A former student of Douglass North, Munger emphasizes the transaction cost angle throughout:
To succeed, a middleman has to reduce three key transactions costs:
• Provide information about options and prices in a way that is searchable, sortable, and immediate
• Outsource trust to assure safety and quality in a way that requires no investigation or
effort by the users
• Consummate the transaction in a way that is reliable, immediate, and does not require negotiation or enforcement on the part of the users
“They can’t touch me. I do my homework”
How much investment due diligence is enough? How much is too much?
The amount of research an investor should do before making an investment depends on three factors: 1) Size of Position 2) Illiquidity of position, and 3) Contrary nature of position.
The Kelly Criterion is a good heuristic, although in real life we never know exact probabilities. Most investments will succeed or fail on one or two factors. The key is to identify those and understand them better then the person selling to us. Anything beyond that is just for fun. Indeed a lot of investors really like to dig. But the 80/20 rule applies. Think jiujitsu not powerlifting.
Position sizing is part math and part psychology. The bigger a position, the more a person has to check and double check. This isn’t just a number in a spreadsheet. Conduct a premortem. What is the maximum pain you can take? The only way to survive a large position going against you is to have the confidence in your research.
Its critical not to get causation wrong here. If “concentration” is part of one’s identity as an investor, there is a major risk confirmation bias will takeover and more research will just make them more sure of a false idea. Remember smarter people are actually at greater risk of confirmation bias.
If the facts lineup, it might make sense to “go for the jugular”.
For most individual investors, illiquidity is a secondary concern. Nonetheless an investor must consider it. An investor can easily sell a widely traded stock or ETF. But for illiquid positions, an investor needs to learn that information ahead of time.
Decisions that are easy to reverse can be made quickly. Decisions that are difficult or impossible to reverse require more analysis up front.
Markets are usually right. The more out of consensus a view is, the more data and analysis an investor must have to back it up. “Who is on the other side?” is probably the most important question in investing. I’m only comfortable if I understand the contrary position better than people who hold it.
Active investing requires active thinking.
With investment research an hour of active critical thinking is worth more than a week of passive reading
Techniques of due diligence depend on what’s available, and also on an individual personality. Some people are good at plowing through footnotes or analyzing sentiment data, others are highly skilled at interviewing industry experts. Since computers read 10-Ks the minute they come out, its essential to get creative with due diligence, but this does not mean digging for the sake of digging.
I was researching, a venture capital focused business development company (BDC) liquidation. Its investments holdings consisted of preferred stock in 11 venture stage companies, with most of the value concentrated in the top five holdings.
Although there was limited publicly available information on the financial condition or valuation of each individual holding, the filings disclosed the aggregate range and average of the metrics and assumptions used by the company in the valuation process to arrive at fair value of Level 3 Assets on the financial statements. My interest was piqued when I noticed that other public BDCs that owned some of the same asset were marking them at much higher prices. Nonetheless, I needed to verify the viability, and growth potential of the main underlying businesses.
I approached this issue from multiple angles:
One of the company’s largest assets was preferred stock in a company that operated a dating site. With permission from my wife, I set up a fake profile to see how the interface of the website and app worked, and to verify that there were indeed a large number real people using it in my area, and a few other cities I checked. This helped me corroborate information from user reviews I had read.
The company owned stock in a highly specialized medical testing startup. I reviewed the background of top employees on LinkedIn, university websites, and various scientific journals. Additionally I discussed the business idea with friends in academia. They verified that the idea had a reasonable chance of working, and would require an advanced degree to replicate.
Accounting rules gave management ample discretion on how to report the holdings on the balance sheet. I carefully reviewed everything they had disclosed about their valuation process, and tracked changes in language between different filings over time.
I also contacted the management of the BDC, and was able to reach the people in charge of the valuation process on the whole portfolio. They helped me understand the facts they were using to justify the valuations supplementing my careful reading of the public disclosure. The conversation verified that the BDC was indeed serious about liquidating its portfolio. Further they candidly reminded me how valuing the portfolio conservatively made the tax consequences of converting to a liquidating trust more favorable for investors(the management group was also a large shareholder).
I did a lot of unconventional work, but didn’t mindlessly dig for more info. It wasn’t a huge position but since its going to be locked up in a non transferable liquidiating trust, and it was an idea most people thought too ugly, a bit of extra work was justified.
The company already paid back most of my initial investment after selling one investment and the portfolio still has a lot of value. The true test will be in the final IRR when its all said and done.
See also: The hard thing about finding easy things
“My God, they’re purple and green. Do fish really take these lures?” And he said, “Mister, I don’t sell to fish.
Informational edge can drive fantastic alpha while it lasts. This explains the increasing investment industry focus on non-traditional data sources, aka alternative data. If you are the first to acquire a new alternative data set, you might be able to develop insights no one has.
Yet once a lot of people are using it, it is less likely to drive alpha. It might be table stakes to not get screwed, or it might be already be instantaneously reflected in the price of assets.
Furthermore, most opportunities really hinge on a couple factors- more info isn’t always useful. That won’t stop the alternative data industry from doubling to $400 million by 2021, as a widely cited Tabb Group report predicts This is worth considering while one is caught up in an alternative data arms race.
Yet some data sets genuinely will provide an edge.
Perhaps a data set that no one else is looking at provides the edge you need. If a data set isn’t established as useful, the provider of that data will probably offer it cheaper in the early days of their business. There are so many alternative data providers out there, that marketing strategy is important for startups.
Ironically, the provider can charge higher price once word about its value gets out among investors.. So later adopters might pay more for an edge that is already gone.
Of course eventually someone will put all the data online for free and meta data of how investors use that alternative data can also be useful.
Now can I interest you in an alternative data feed that will make all your dreams come true?
Investing goes through fads. Investing strategies and fund structures(1) go in and out of style. Nowadays long/short hedge funds are out and infrastructure funds are in. Within the public equity markets, value is out, growth/momentum is in. Each time this happens, people forget how the cycle repeats.
In fact, one CIO contended that if he brought a hedge fund that paid him to invest to his board, the board would dismiss it without consideration — simply because it’s called a hedge fund, and hedge funds are bad.Institutional Investor
Hedge funds may have to do a name change if they want to raise capital.
Remember last time?
And yet people forget:
Allocators woke up craving the next rising hedge fund star and couldn’t invest enough at high and increasing management fees after the widespread success of long-short funds in the weak equity markets of 2000-2002. Board rooms back then castigated CIOs for not having long-short equity hedge funds in their portfolios.
This isn’t the first time:
People forget that 40 years ago, officials such as Paul Volcker of the Federal reserve wanted an active hedge fund industry to absorb the risk that was not well managed by state-insured banks.Financial Times
Each investment strategy picks up a certain type of risk(and potentially earns a profit in doing so)- if a strategy disappears that particular risk can become a systemic issue. Fortunately, around this time it also becomes more lucrative to bear the risk others are unwilling to bear. Eventually the risk reward tradeoff starts to make sense again.
Different, different, yet same
In the 1960’s Warren Buffett put up ridiculous returns, and Alfred Winslow Jones proteges profitably exploited anomalies in markets. By the mid 1970’s of there were many articles about hedge funds shutting down though. Industry AUM declined ~70% peak to trough. Nifty fifty boom and bust followed by the long nasty bear market. But as the institutional architecture of international trade and currency shifted we entered glory years of global macro/commodities traders. Then the 80’s were great for Graham deep value and Icahn style activist investing after the 70’s bear market left a huge portion of the market selling below liquidation value.
Likewise late 90’s again saw the death of hedge funds as day traders in pajamas earned easy returns from the latest dot-com- until the crash. Yet out of the rubble of the tech bubble rose a new generation of great hedge fund managers. There was rich pickings for surviving value hunters- and those with the guts and skills to execute became household names a few years later. Many value managers that nearly went out of business during the tech bubble put up ridiculous numbers 2000-2002 and through the next financial crisis. (See: The arb remains the same)
The greatly exaggerated death of a style gives rise to an environment where there is a plethora of opportunities for something similar to that style to work. Each time the narrative in the greater investment community favors some type of uniform strategy, and LPs give less capital to other strategies- causing them to nearly die off. But then the lack of people pursuing the out of fashion strategy makes its return potential more lucrative. Eventually someone finds a new method to pick up those dollar bills on the ground that shouldn’t exist.
Economics emphasizes rational actors and equilibrium. Yet the messy reality is far more complicated. Ecology is a far more useful mental model.
A giant self over-correcting ecosystem
There is in ecological function to speculative capital and over time there should be some excess returns to those willing to take mark-to-market lossesFinancial Times
Like biological species, financial strategies can have competitive, symbiotic, or predator-prey relationships. The tendency of a market to become more efficient can be understood in terms of an evolutionary progression toward a richer and more complex set of financial strategies.Market force, ecology and evolution
Ecology emphasizes interrrelationships between different individuals and groups within a changing environment, and indentifies second order impacts.
Thinking like a biologist
One can develop a useful framework by replacing species with strategy, population with capital, etc
Flows and valuation interact, self correct, and overshoot.
….capital varies as profits are reinvested, strategies change in popularity,and new strategies are discovered. Adjustments in capital alter the financial ecology and change its dynamics, causing the market to evolve. At any point in time there is a finite set of strategies that have positive capital; innovation occurs when new strategies acquire positive capital and enter this set. Market evolution is driven by capital allocation.
Market evolution occurs on a longer timescale than day-to-day price changes. There is feedback between the two timescales: The day-to-day dynamics determine profits, which affect capital allocations, which in turn alter the day-to-day dynamics. As the market evolves under static conditions it becomes more efficient. Strategies exploit profit-making opportunities and accumulate capital, which increases market impact and diminishes returns. The market learns to be more efficient.
When an ecoystem is overpopulated with a certain species, it eventually overshoots and results in mass starvation. Populations fluctuate wildly across decades, and sometimes species go extinct or evolve into something that seems new.
New conditions give rise to new dominant species.
(1) Although I am frequently pedantic about the differences between structure, strategy, and sector, many in the media seem to use these interchangeably when discussing reversion to mean situations. Fortunately they all exhibit the same boom/bust phenomenon, so I am using them interchangeably here.
Imagine if Warren Buffett of 1960 puts down the deadtree 10-K he got in the mail and time travels forward to 2019. Then he looks over the shoulder of an analyst at present day O’Shaughnessy Asset Management. He would find the scene unrecognizable.
Or, if the original Jesse Livermore time traveled from the 1920s stock exchange to the present day trading floor of DE Shaw or Renaissance. Again, completely unrecognizable.
Back in the day people went to the SEC office in the Washington DC to access annual reports faster. That was how one got a fundamental edge. Now people scrape filings the minute they come out. Or use satellites and credit card data to get an edge on information before it hits regulatory filings. People used to gauge momentum by looking at the facial expressions of other traders, now they use complex computer models. People mine market and fundamental data around the globe looking for a bit of an edge. New techniques, same thing.
Over time there is the change in the physical activities, and words we use to describe the process of identifying and exploiting market inefficiencies. Nonetheless the ecological function is the same. Investors are just looking for mispriced risk, and exploiting it till its no longer mispriced.
Around the world there are unfair coins waiting for someone to flip them. Arbitrageurs will need to use weirder and weirder methods to find and exploit them. Methods change, but the arb remains the same.
Two main factors drive an upsurge in entrepreneurship: cheap stuff and cheap capital. Cheap stuff is primarily a long run secular trend. Cheap capital is cyclical.
By cheap stuff I mean the inputs to a business, mainly technology. This has gone consistently down over time. One can build a website or an app for a few thousand dollars that is better than what they could have done for millions of dollars a decade ago.
Even if capital becomes scarce, cheap stuff will still be a positive factor driving entrepreneurship.
By cheap capital I mean the flood of venture capital. This is primarily cyclical. Consider this quote:
“There’s so much money chasing these deals that venture capitalists are in competition with each other. They spend their energies marketing themselves instead of screening the deals. It’s gotten silly”
Think it applies today? Or maybe to the late 1990s tech boom? This quote is from the WSJ in 1981, and referenced in this excellent article about 1980s venture capital.
During a boom its easy for most ideas to raise capital, regardless of business viability(as long as they fit with theme of the times). Indeed they can keep raising rounds in hopes of a profit decades in the future. After a bust its hard to raise capital, even for a great idea. Entrepreneurs need to bootstrap and get revenue a soon as possible.
Right now it seems there is a ton of venture capital financing companies that are losing money.
Cheap stuff and cheap capital are partly entangled. You might be reading this from within a WeWork. If they couldn’t keep raising cheap capital you think your rent is going to stay the same? Or maybe you are building a business on top of a money losing social media platform, or somehow benefiting from a thriving open source ecosystem. On the other hand, its harder to source talent when there is a flood of capital, and certain commodity based goods can have their own production cycle. Yet you can run your business from a garage and the new inventions of the latest venture boom aren’t going away.
Which is most important- cheap stuff or cheap capital ? I don’t know, but we’ll get to find out when this cycle turns. Creative entrepreneurs will still take advantage of technological improvements to bootstrap groundbreaking ideas, even if they can’t raise venture capital. Sometimes they do it out of choice, other times they do it out of necessity.
Once this cycle turns, we’ll go through a few years where most new businesses have no choice but to bootstrap.
This idea generally applies across all industries, not just venture funded. However in commodity based industries the cyclicality functions differently. Cheap capital often leads to inflation in hard assets. See also: Capital Returns: Investing Through the Capital Cycle
Hyman Minsky developed a framework for understanding how debt impacts the behavior of the financial system, causing periods of stability to alternate with periods of instability. Stability inevitably leads to instability. Minsky identified three types of financing: Hedge financing, speculative financing, and ponzi financing. It seems some people only remember Minsky every so often when there is a financial crisis, but the framework is useful in all seasons.
An asset generates enough cash flow to fulfill all contractual payment obligations. For example, a conservatively leveraged rental property that generates enough rent to pay down the entire mortgage over time, regardless of the change in quoted property prices. Or a company that issues some bonds, then pays them back using cash flow from the business Generally hedge financing units have a lot of equity down. Even a market crash, will not cause an investor to suffer permanent capital impairment if they only use hedge financing. The equity holder who uses hedge financing will never depend on the capital markets.
An asset generates enough cash flow to fulfill all debt payments, but not the full principal amount. In this case debt must be rolled over, or the asset must be sold, in order to pay back the full amount. For example, a rental property financed with some sort of balloon payment structure that generates enough cash flow to pay off mortgage payments up until the balloon payment at the end. When the balloon payment comes due, the investor must roll over the debt or sell the asset. An investor ttat uses speculative financing is dependent on capital markets. If there is a delay or a problem in refinancing, they could lose their investment.
This is basically “greater fool” investing. Ponzi financing means there is so much leverage n an asset, that the investment must be refinanced, or sold at a higher price quickly, otherwise the entire investment is lost. Sometimes property purchases will be financed with shorter term bridge loan. If the bridge loan can’t be refinanced with longer term mortgage, the investor is out of luck. Towards the end of the market cycle, many companies will be issuing bank loans or bonds that can only be repaid by refinancing. If their unable to refinance, they go bankrupt.
Use of ponzi financing means the investor is highly dependent on capital markets. The slightest disruption in capital markets or change in interest rates/inflation results in a large capital loss.
Junk bonds are not inherently bad. A higher interest rate can in many cases compensate for greater risk, especially across a portfolio of non correlated investments. Howeve, duringthe junk bond era, many companies
Similarly securitization is not inherently bad. It can allow capital to flow more effeiciently. But often banks would end up aggressively securitizing, with the need to sell the loans they made quickly. But if they weren’t able to resell they couldn’t hold the loans. This happened to Nomura during the Asian financial crisis, as vividly told in this Ethan Penner interview.
Ponzi in this case is not illegal activity, just extremely risky. Of course those investors who finance their activities ponzi style often end up feeling the need to commit illegal acts. The Minsky Kindleberger model is useful here.
The cycle repeats
During a recession is very difficult to get any debt financing that is not “hedge financing”. Lenders are scarred from the last cycle, and there is a paucity of available risk capital. But a price rise, and investors get more comfortable, more and more financing becomes ponzi units In fact. Lenders may lower their standards and become more accepting of ponzi units.
Throughout the market cycle, more and more financing is ponzi units. Eventually there is no greater fool to sell to. When many ponzi units are forced to sell at once, it eventually leads to a collapse in values. This is how stability inevitably leads to stability. The cycle repeats.
How to apply this?
To protect my capital, I look try to mainly expose myself to hedge financing, with a small amount of speculative financing. I position my portfolio so that I don’t need to refinance anything or sell anything in a rush. When I invest in leveraged companies with speculative or ponzi financing, I make it small position(always in some sort of limited liability structure), and generally won’t average down much if at all. Additionally, when I notice an increase in ponzi financing in the markets, I become more cautious.
Leverage, like liquor , must be consumed carefully if at all.