It's been a busy few months, which explains the long blogging hiatus. But in the last 6 weeks, I've been on something of a "value" reading binge, which will hopefully set the stage for a series of posts. The first of these focuses on Lawrence Cunningham's "The Essays of Warren Buffett". I have to admit that I hesitated to write this post. It's Buffett. There's been so much written on the man that it's virtually impossible to say anything original. So set your expectations accordingly, but as with all my posts, recording my thoughts is as much for myself as for a general audience. Another reason to write the post is that, with the general adulation Buffett is afforded by value investors, there is far too much out there that aims to ape Buffett - poorly. Even the ideas of luminaries like Buffett should be subject to scrutiny for their objective truth, and their subjective relevance to the individual investor.
By the way, these letters are all available for free online, but I was happy to spend a little money and have some of the wisdom distilled for me.
On, then, to the themes:
Simplicity
Cunningham's book starts with the following two quotes:
"The speech I love is a simple, natural speech/ the same on paper as in the mouth/ a speech succulent and sinewy, brief and compressed/ not so much dainty and well-combed as vehement and brusque." - Michel de Montaigne
"The sincerity and marrow of the man reaches to his sentences. I know not anywhere a book that seems less written. Cut these words and they would bleed; they are vascular and alive." - Ralph Waldo Emerson
These may seem like odd choices to begin a book on an investor, but Cunningham knows what he's doing. It's impossible to ignore the clarity of Buffett's writing and thinking (not to mention the considerable wit that shines through). This was reinforced as I was reading Mohnish Pabrai's excellent "Dhandho Investor" (which will be the subject of a later post, when I finally get around to it). Pabrai draws a parallel between Einstein and Buffett (though even Buffett would surely be a bit embarrassed to be compared to Einstein). Pabrai writes, "Einstein noted that the five ascending levels of intellect were, "Smart, Intelligent, Brilliant, Genius, Simple." For Einstein, simplicity was simply the highest level of intellect. Everything about Warren Buffett's investment style is simple. It is the thinkers like Einstein and Buffett, who fixate on simplicity, who triumph."
One example of this simplicity is Buffett's concept of owner earnings, which is basically normalized free cash flow to equity. While I have used a similar concept in my own analyses, I used a much uglier phrase that I masked with an equally ugly acronym (so ugly that I'll spare readers!). The use of the simpler "owner earnings" cuts to the heart of the analysis, and to the heart of the valuation question.
Some make the grave error of confusing the simple with the simplistic. This error runs in both directions. Some are unable to see the beauty and resilience of simple ideas, preferring the complex and fragile. Others may cling to simplistic but sub-optimal ways of thinking. It's a challenge to cull extraneous ideas while retaining the essential.
In addition, Buffett's simple, clear writing suggests a level of comfort with himself. This mirrors his investment style - admittedly shaped over a long, successful career. As I elaborate below, there is a tension between finding one's own style and absorbing the lessons of great professionals.
Organizational Structure
Another focus is on building the right organization. As Buffett writes, "We have carefully designed both the company and our jobs so that we do things we enjoy with people we like." There are two levels to this. The first is relying on top-notch lieutenants at Berkshire. Hathaway. Berkshire is a massive operation, and it again requires a kind of simplicity to have it run effectively. Several quotes illuminate Buffet's thinking on this.
- "Having first-rate people on the team is more important than designing hierarchies and clarifying who reports to whom about what and at what times."
- He also quotes David Ogilvy: "If each of us hires people who are smaller than we are, we shall become a company of dwarfs But, if each of us hired people who are bigger than we are, we shall become a company of giants."
Most of us will never run entities on the scale of Berkshire (nor would most of us want to!). But there is another set of stakeholders with whom to build relationships, i.e. underlying investors. Buffett makes abundantly clear the immense amount of thought that has gone into attracting the right investor base at Berkshire. An investor base out of sync with the manager's philosophy is a recipe for disaster and unhappiness.
Suffice to say, the end result for Buffett has been overwhelmingly positive: "To almost a sinful degree, we enjoy our work as managing partners." Furthermore, "we enjoy the process far more than the proceeds - though we have learned to live with those also."
Elements of Buffet's Investing Philosophy
There is a lot of specific detail to be gleaned from the letters, but I'll focus on broader lessons. Perhaps the best expression of Buffett's philosophy is as follows: "In my opinion, investment success will not be produced by arcane formulae, computer programs or signals flashed by the price behavior of stocks and markets. Rather an investor will succeed by coupling good business judgment with an ability to insulate his thoughts and behavior from the super-contagious emotions that swirl about the marketplace." I liked that quote because it encapsulated various sub-themes:
a) Humility - knowing one's limitations
-"Charlie and I decided long ago that in an investment lifetime it's too hard to make hundreds of smart decisions."
- "by confining himself to a relatively few, easy-to-understand cases, a reasonably intelligent, informed and diligent person can judge investment risks with a useful degree of accuracy"
- Buffett quotes Keynes: "As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one's risk by spreading too much between enterprises about which one knows little and has no reason for special confidence. One's knowledge and experience are definitely limited and and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence." Keynes was hardly known for his humility, so these musings are worth taking seriously.
- "What counts for most people in investing is not how much they know, but rather how realistically they define what they don't know. An investor needs to do very few things right as long as he or she avoids big mistakes."
- "we favor businesses and industries unlikely to experience major change"..."If others claim predictive skill in [fast-changing] industries - and seem to have their claims validate by the behavior of the stock market - we neither envy nor emulate them."
This humility is often a hard-won lesson from making errors. But a devotion to learning from one's mistakes is essential:
- "It's a good idea to review past mistakes before committing new ones".
- "A prime rule of investing: You don't have to make it back the way that you lost it."
b) Contrarian thinking, i.e. doing things that are unfashionable
On the one hand, it's an expression of humility to avoid popular areas where one has no comparative advantage. On the other hand, it's an act of striking confidence in one's own path to ignore the herd's collective drive.
- "as happens in Wall Street all too often, what the wise do in the beginning, fools do in the end"
- "the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs."
- "if [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful."
One of the most contrarian things in the world of investment management is to do nothing:
- "Inactivity strikes us as intelligent behavior."
- "Lethargy bordering on sloth remains the cornerstone of our investment style."
Yet this seeming indolence is but preparation for a time of energy and activity:
- "during the episodes of financial chaos that occasionally erupt in our economy, we will be equipped both financially and emotionally to play offense while others scramble for survival."
- Buffett acknowledges that this is easier said than done: "Unlike [baseball player Ted Williams], we can't be called out if we resist three pitches that are barely in the strike zone; nevertheless, just standing there, day after day, with my bat on my shoulder is not my idea of fun."
c) Flexibility
While the power of the value investing framework speaks deeply to me, dogmatic interpretations of Buffett's record always annoy me. It's clear that one can be simplistic, not simple, when trying to characterize his success. Flexibility has been an important quality.
- One example is Buffett's early foray into arbitrage at Rockwood & Co., unlocking the hidden value of inventory (cocoa beans) despite the company's operating losses. As Buffett remarks succinctly, "Sometimes there is more to stock valuation than price-earnings ratios."
-"An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline."
d) The uses and abuses of quantitative methods
Buffett is terrifically numerate, and from all accounts, an outstanding judge of the risk-reward trade-off. Yet he is selective when using numbers in his investment process:
- "the difficulty of precisely quantifying [the primary factors in investment analysis] does not negate their importance nor is it insuperable."
- "Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach. Calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong. The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base."
e) Temperament
The importance of equanimity in investing is something close to my heart, shown by previous posts. Buffett agrees on its importance as a component of a skilled investment mind:
- "We need someone genetically programmed to recognize and avoid serious risks, including those never before encountered...Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success."
Keep calm, Buffett disciples, but I have to disagree with him here. Perhaps it's unfair to hold him to the turn of phrase, but surely one doesn't need to be "genetically programmed" to follow the investment path he espouses. I recently heard a fascinating 2-part interview with Dr. Ed Taub (see here and here) on Constraint-Induced Movement Therapy (CI Therapy). CI Therapy is a revolutionary approach to physical rehabilitation for stroke and other central nervous system injuries. Based on the principles of brain plasticity, it has several components, of which the most important are (a) repetitive, task-oriented training and (b) the transfer package, i.e. adherence-enhancing behavioural strategies. The parallels with investing are clear. For those lacking Buffett's preternatural "genetic" gifts, hard work and dedication to the investing craft are the next best thing.
With some luck, there will be more posts on Buffett's disciples in the following weeks.
In 2011, venture capitalist Marc Andreessen wrote a much vaunted essay in the Wall Street Journal entitled "Why Software Is Eating The World". The phrase "XYZ is eating the world" has become standard fare for explaining how some new technology is disrupting old ways, and improving the lives of consumers in the process. Generally, this is seen as a good thing. Sophisticated (i.e. non-Luddite) commentators rightfully fret over the effects of technology on employment and inequality, but it is virtually unheard of for anyone to criticize the improvements offered by advances in technology.
Finance, on the other hand, continues to be reviled as an industry. It's pretty difficult to get the Tea Party and the most left-leaning wing of the Democratic Party in the US to agree on anything, but suspicion of, and antipathy towards, the financial industry seems fairly unanimous. Some of this is self-inflicted, through a never-ending series of scandals and understandable concerns about the power of the finance lobby. But we rarely hear the mainstream media articulate things the industry does well, or even the notion that finance can disrupt staid industries for the better. Take, for example, a steady drumbeat of positive press about the solar industry. My impression is that potential disruption to the archaic utility model is widely considered a good thing, with interlopers like SolarCity generally garnering positive coverage. Rarely covered, though, is that finance (and its red-headed stepchild, securitization) is an intrinsic part of SolarCity's business model. The company itself dutifully discloses in its annual report, "Our future success depends on our ability to raise capital from third-party fund investors to help finance the deployment of our residential and commercial solar energy systems." One might go so far as to argue that SolarCity is in the business of creating safe assets, and solar systems are merely an input in the process. So maybe, then, it's finance that's eating the world.
I can't imagine many people would be comfortable uttering that last sentence. The entry of finance into hitherto pristine fields such as commodities (that's sarcasm) has given rise to an ugly word, "financialization". The debate continues as to whether financialization has contributed to heightend volatility in these markets. To some extent, it seems clear that a common investor base increases the covariance of assets. But financialization may be getting a bad rap when it comes to creating increased volatility. In an excellent article on Keynes's approach to endowment management, Chambers and Dimson highlight his sensitivity to liquidity risk. Ever incisive, Keynes wrote, "Some Bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each Audit, would turn their hair grey. The fact that you do not [know] how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one." Financialization may merely reveal the underlying volatility of asset classes such as real estate and commodities, which is unsurprising given the long known inelasticity of supply and demand. Did a move to spot market pricing create the vicious fluctuations in the iron ore market, as has been argued by some industry executives? I, for one, am skeptical. Furthermore, financial players clearly provide liquidity and produce information for markets.
Finally, a common criticism is that financial players are merely engaged in rent-seeking, rather than generating genuine social value. A recent article by Harvard economics professor Sendhil Mullainathan captures these concerns, which I share. Mullainathan's balanced treatment does, however, do a nice job of addressing the ambiguity of what constitutes rent-seeking. Thankfully, this doesn't need to be decided in a court of law by a Solomonic judge. The market is a wonderful device for decentralizing this judgment, and it usually works quite well. Broadly speaking, I think we have passed the days when the average person in finance made extraordinary sums disproportionate to his value (and a damned good thing too!). As examples, this has manifested itself in industry job losses and unceasing pressure on fees to investment managers. At a higher level, the combination of government regulation and investor pressure have convinced most large financial firms that simpler, more robust structures are preferable. The market, in other words, has penalized firms for being unwieldy and producing little value in return for increased complexity.
None of this should be misconstrued as my saying that the industry is omniscient or morally unblemished. It merely means that we should continue to encourage the expansion of finance, even though mistakes will be made. Experimentation is a messy affair, and is particularly challenging in financial markets, which are complex adaptive systems that can be highly unpredictable. But as Mullainathan writes, "I hope [students going into finance] realize that they have the potential to do great good and not simply make money. It may not be how the industry is structured now, but idealism and inventiveness are two of the best traits of youth, and finance especially could use them." I'm reasonably optimistic that creative finance and dynamic technology will continue to disrupt stale models of thinking, benefiting end consumers. After all, if finance is eating the world, perhaps the world is ripe for eating.
John Arnold isn't a household name, but those involved in the US energy markets will recognize him as an incredibly successful energy fund manager. Arnold cut his teeth as a trader at Enron, and then started Centaurus Advisors, an energy-focused hedge fund in Houston, reportedly building up a net worth of $4b. It thus came as a surprise to many observers when he announced his retirement from Centaurus in 2012 at the age of 38.
In typical Arnold fashion, he appears to be flying under the radar in his second career - though, again, with the occasional big bang. In May 2013, Arnold and his wife were featured in the WSJ for their philanthropy - not simply for writing big checks, mind you, but for taking a keen interest in the efficiency of their contributions, and for being willing to fund projects of uncertain value with potentially large payoffs. As the WSJ reports, "The Arnolds want to see if they can use their money to solve some of the country's biggest problems through data analysis and science, with an unsentimental focus on results and an aversion to feel-good projects - the success of which can't be quantified."
This type of philanthropy isn't new. Bill Gates seems to be the prototype for a guy who's made a lot of money in one field and hurls himself into the weeds of philanthropy. But it does seem to be catching on. No doubt there are various reasons for this, but one can easily point to the increased sophistication of programme evaluation, the larger influence of business and finance types as donors, as well as a general wave of enthusiasm for all things "evidence-based" (evidence-based medicine, evidence-based journalism, evidence-based investing... all good, but what were people doing before?). In their book Poor Economics, Duflo & Banerjee highlight the growing use of randomized controlled trials in development economics. Their line of thinking proposes that "it is possible to make very significant progress against the biggest problem in the world through the accumulation of a set of small steps, each well thought out, carefully tested, and judiciously implemented."
I find this way of thinking very appealing, particularly for its potential to compare the payoffs from competing development or philanthropic strategies. It's no surprise that we often let affinity and empathy obscure our thinking in these issues. By this I mean that we find it easier to contribute to our own communities and countries, even though there are often considerably greater needs once we cast our gaze slightly further afield. Rigorously collecting and evaluating data seems to offer a path to quantify the costs of myopic charitable giving.
As a result, I've been wrestling over the past few months with how to frame philanthropy as a form of investing. The aim should be to maximize the net present value of charitable giving. But there are two weaknesses with this approach. First, this sort of philanthropy is probably much easier for the very rich, who have the means to guide recipients into providing reams of data. My sense is that it is quite hard, as a small donor, to get much insight into the full working of organizations. And, second, the truth is that even if the data were available, I've struggled mightily with how to think about the incremental benefit of donor dollars, and the appropriate discount rate.
In his book The Life You Can Save, Peter Singer makes the point that "there are many organizations doing good work that offer opportunities worth supporting, and not knowing which is the very best shouldn't be an excuse for not giving to any of them." In fact, he goes so far as to argue that "some uncertainty about the impact of aid does not eliminate our obligation to give."
I disagree with the last assertion. If we have an obligation to give, we have an equal obligation to ensure that we are giving well. Angus Deaton disagrees at an even more fundamental level. In his book The Great Escape, he surprisingly denounces most forms of charitable giving, particularly foreign aid. "What surely ought to happen is what happened in the now-rich world, where countries developed in their own way, in their own time, under their own political and economic structures... We need to let poor people help themselves and get out of the way - or more positively, stop doing things that are obstructing them."
Yet he doesn't think all forms of giving are unhelpful. Deaton goes on to make two distinctive arguments for giving to universities. I've often thought of giving to universities (especially one's own alma mater) as a form of vanity giving, particularly with the thriving endowments many universities have today. But Deaton makes two good counter-arguments:
1) "As the economist Jagdish Bhagwati has argued, it is hard to think of substantial increases in aid being spent effectively in Africa. But it is not so hard to think of more aid being spent productively elsewhere for Africa." In particular, Deaton suggest funding basic research on health and agriculture.
2) "The effects of migration of poverty reduction dwarf those of free trade... A helpful type of temporary migration is to provide undergraduate and graduate scholarships to the West, especially for Africans. With luck, these students will develop in a way that is independent of aid agencies or of their domestic regimes." (In similar fashion, see Michael Clemens on why migration should be a major part of the UN's Sustainable Development Goals).
More importantly, perhaps, the notion of doing the most good with any specific type of giving is probably unnecessary. One of the basic tenets of investing is diversification. Similarly, it probably makes sense to think of charitable giving as a portfolio, mixing bets of different individual risk, reward, and with little overlap (i.e. low covariance).
Finally, just as I wouldn't suggest a complete novice spend his time on security analysis or asset allocation, perhaps novice donors don't need to spend copious amounts of time dissecting philanthropic organizations. Intermediaries such as GiveWell have made it easier to learn about NGOs who are doing important work.
These may not seem like the most exciting, or even the most personally satisfying forms of philanthropy. But just as disciplined investing isn't always exciting, I'm starting to believe that philanthropy can quite reasonably be seen as a way to combine a rigorous view of individual organizations with the benefits of diversification to obtain the best long-run outcome with one's giving.
It's slightly surprising that it's taken me this long to get to it, but I finally read Gregory Zuckerman's "The Greatest Trade Ever", which documents John Paulson's multi-billion dollar score in the real estate crisis of 2007-2009. Zuckerman puts Paulson & Co.'s winnings at $15b in 2007 (with astonishing gains of 590% and 350% in its two credit funds), and a further $5b in 2008 and early 2009. I'm actually glad I waited a few years to read this, because it affords some historical perspective on the trade itself and Paulson's results since then.
A quick review of the book is in order before I launch into some lessons learned. It's a scintillating read, and captures the boom and bust in real estate and associated securities, as well as prior episodes of market mania. It is certainly a difficult task to write a page-turner about credit derivatives, but Zuckerman succeeds admirably. In addition, he seems balanced and even-handed in his treatment of the colourful array of characters, offering wonderful snapshots of the mania that pervaded investment management, and the ensuing collapse.
Now, on to some of the many things I learned from the book:
1) Macro matters. It won't surprise you if you've read other posts of mine, but yes, macro matters. This was essentially a macro bet. Contrary to some views that decried Paulson as a "tourist" from the merger arb space, he had proven to be "gutsier, playing the merger game differently than his peers. He began to short companies set to be acquired when he deduced that their merger agreements might collapse." This penchant for a more creative approach led Paulson to his most famous set of trades.
Zuckerman lays out the (not always totally correct) macro framework that guided Paulson's thinking:
- In 2004, Paulson became concerned about who would be exposed when the Fed began raising interest rates.
- In early 2005, as Paolo Pellegrini suggested shorting mortgage securitizations, Paulson decided the Fed wouldn't want to lower rates to help borrowers because it might weaken the dollar further and stoke inflation.
- In late 2005, Paulson "trimmed holdings that seemed especially sensitive to the economy and shorted the bonds of others".
- By late 2007, Paulson recognized the impact a real estate and credit collapse would have, shorting shares of banks with significant exposure to the credit card business and those making commercial real estate, construction, and other risky loans. He also shorted Fannie and Freddie on the same premise.
2) Luck matters. There's no doubting the brilliance of the trade, and the nerve that it took to pull it off, but luck played a healthy role too. Paulson was early enough to have time to refine his trade, and late enough not to suffer excessively while the housing market stood firm. It's remarkable that Paulson started from knowing nothing about CDS in Oct 2004, and had time to revise his trade several times. In November 2005, "the Paulson team's original thesis, that a spike in interest rates would cause problems for home owners, seemed dead wrong." Paulson sold his original CDS protection after concluding that it covered mortgages on homes that already had enjoyed so much appreciation that refinancing would be easy. This seemed to happen again in 2006, but they were able to roll protection into the latest vintages. As Zuckerman writes, "Paulson had dodged a bullet." The trade also evolved as the team's views on housing matured. Incredibly, until early 2006, "Paulson's team hadn't put much thought or research into whether housing prices were bound to tumble
But, fortunately for him, he wasn't too early. Zuckerman notes that, "Paulson also had good fortune on his side: By the time he determined that the housing market was in a bubble in the spring of 2006, prices had begun to flatten out, making it the perfect time to bet against the market. Others who had come to a similar determination much earlier were licking their wounds because they had placed wagers against real estate too early and suffered as it climbed further."
Finally, Paulson was lucky to be an outsider. "It was fortuitous that Paulson was a merger pro, and not a veteran of the mortgage, housing, or bond markets. He wasn't deterred by the dismal track record of those who already had bet against housing, and wasn't fully aware that his bearishness wasn't especially unique."
That said, I don't want to overstate this element. It obviously took a tremendous amount of work to get up to speed on an arcane market. Other prominent managers demurred at taking such an outsized bet. "Paul Singer of Elliott Management Corp. and Seth Klarman of Baupost Group bought some CDS insurance contracts on risky mortgages but chose to buy small portions of it and not go overboard." "Buying so much was a reputational risk," Klarman says, "It wasn't a no-brainer." Zuckerman also details how Paulson avoided getting cold feet in 2007 when the trade seemed to have worked partially. Furthermore, he successfully played both sides of the trade, profiting on the long side by 2009. Others, like John Devaney, faced serious losses by re-entering the market too early. All in all, this was the confluence of luck and skill, with Paulson correctly reading macro forces, real estate-specific drivers and investor sentiment.
3) Lucky or not, being an outsider helps sometimes. Zuckerman quotes Bertrand Russell: "The fact that an opinion has been widely held is no evidence whatsoever that it is not utterly absurd; indeed, in view of the silliness of the majority of mankind, a widespread belief is more likely to be foolish than sensible." One stunning example Zuckerman cites is the "discovery" by Deutsche Bank analyst Eugene Xu that "home prices had been key to loan problems for more than a decade, including during the mini-downturn in real estate in the early 1990s." If you're scratching your head that this should be a revelation, Zuckerman goes on to say that "at the time it was quite a radical viewpoint. Most economists and traders figured that a range of factors, including interest rates, economic growth, and employment, determine the level of mortgage defaults." I found it interesting that two outsiders, Paulson and Greg Lippmann, were communicating and helping to reassure one another. Sometimes this is the path to breaking through dogma; sometimes it results in an unhealthy echo chamber. It's hard to know which is which. In a world where things seem to be getting ever more complicated and specialized, we rely on gatekeepers more than ever. Perhaps the skills most needed are common sense and critical thinking.
4) There are ethical grey areas in investing. Zuckerman duly notes the ethical grey area of Paulson working with bankers to create risky investments. But we shouldn't allow hindsight bias to excessively colour our judgement. "In truth, Paulson and Pellegrini still were unsure of their growing trade would ever pan out." Furthermore, Paulson was betting against supposedly sophisticated investors.
Similarly, Jeff Libert reveals the ethical quagmire he found himself in as he "discovered an odd impulse: He found himself rooting for a rash of home owners to run into problems paying off their mortgages."
5) The emotional strain of a great trade may not be for everyone. Zuckerman vividly describes the strain the trade took on Michael Burry, Jeffrey Greene, Pellegrini and Paulson. Some examples:
- "[Jeff Greene's] very reputation and sense of self-worth seemed tied up with the trade." "If [the trade] doesn't work, I'm cooked", he confided to Jeff Libert.
- Despite a gain of 150% in 2007, Michael Burry was deeply exhausted. "Burry couldn't enjoy his belated success...still weary from the battles with investors and too sensitive to ignore their unhappiness."
Those with lavish lifestyles, such as Pellegrini and Jeff Greene, placed some self-imposed stress on themselves. Perhaps Paulson's earlier decisions to alter his lifestyle provided him with the equanimity to see the trade through.
Most of us will never experience the nerve-wracking strain of a trade like this, and perhaps that's for the best. One of the funniest paragraphs in the book describes Greene meeting his future wife, Mei Sze Chan. Zuckerman writes, "Greene and Chan hit it off. She touched his shoulder. He held her hand. Then they found a quiet spot in the back of the room and began to discuss mortgages.
A few months later they were engaged."
Most of us will have to be content with matrimonial bliss, rather than Paulson's stupendous financial gains. Given the strain he and others underwent in their pursuit of profit, it is a gentle reminder that some of the greatest trades we make happen outside the financial arena.
Like most Singaporeans, I was saddened to learn of the death of our country's founding father, Lee Kuan Yew (LKY). There is little left to be said about his achievements in shaping the history of a small island nation. While LKY's actions have benefited generations of Singaporeans directly, it may well be that his greatest contribution to global welfare will be the creation of an Asian model of political and economic development. Having visited in November 1978, Deng Xiaoping was reportedly heavily influenced by Singapore's success in undertaking economic reform in China. India's Prime Minister, Narendra Modi, has in turn praised the Singapore model and identified it as an exemplar. On a personal level, much of my interest in macroeconomics stemmed from the simple observation growing up that Singapore seemed so much richer than many of its neighbouring countries. This brings to mind Robert Lucas who, speaking about development economics, said, "The consequences for human welfare involved in questions like these are simply staggering: once one starts to think about them, it is hard to think about anything else." LKY's ability to influence economic and social growth in the two Asian giants will ensure that he has a far greater effect globally than on Singapore alone.
The public outpouring of grief and emotion at LKY's passing has certainly taken me by surprise. Obviously, for many people it is an occasion to reflect on the opportunities they have had in life - education, political stability, economic growth, and meritocracy, just to name a few. Far from being complacent and apathetic, Singaporeans have shown a deep sense of gratitude for the strides the country has made, and a profound desire to build on LKY's legacy. I share those sentiments wholeheartedly. It is also a moment to reflect on our mortality, seeing a true giant pass from this world. For those of us with elderly relatives, it is particularly poignant.
Still, the contrarian in me is forced to make several points where I think public perception risks being skewed. First, Singaporeans should not fall for the Great Man Fallacy, and end up believing a monocausal narrative of our country's success. LKY's book, "From Third World To First" is a masterful telling of the complexity behind the nation's growth. (Aside: Blattman and Pepinsky argue that Singapore wasn't a Third World country even at independence. I agree that the narrative might be overstated, but the sustained levels of growth are still impressive). Developing countries don't need One Great Leader; they need strong institutions and a deep bench of competent public servants with integrity. Numerous leaders contributed to Singapore's growth, and I think particularly of Goh Keng Swee, who is generally acknowledged as the real architect of Singapore's economic success. A lovely book on this is "Lee's Lieutenants", edited by Lam and Tan. (Aside #2: Goh's own words on the philosophy behind Singapore's growth are stunningly "Washington Consensus". No doubt my bias towards such a framework in development economics emerges from having enjoyed the fruits of such policies first-hand.) The book rightly presents LKY's greatness as being the superb captain of a team, rather than someone governing in isolation. And of course, economies are complex systems. In addition to the nation's leaders, it is important to pay tribute to millions of anonymous Singaporeans who have contributed to the thriving economy through hard work and a powerful desire to improve themselves.
Secondly, we should be careful not to whitewash LKY's legacy. He was relentlessly clear-eyed as a leader and it would be odd if we didn't subject his legacy to the same level of scrutiny. LKY wasn't a cuddly old man. He was a political force to be reckoned with, and a ruthless opponent when crossed. There is a natural impulse to forgive the ethical trade-offs he and the ruling elite made in governing the country. (See Glenn Greenwald here on a similar approach to Reagan, and Alexander Pantsov here on Deng Xiaoping). If anything, LKY's passing should fill Singaporeans with a resolve to be politically engaged. That doesn't mean engaging in the petty partisan politics that seem to afflict much of the West. It means thinking critically about where we want our society to go, and challenging our political leaders to be outstanding community servants.
None of the points above should diminish the magnitude of LKY's legacy, or the gratitude that Singaporeans feel. He was singularly successful in navigating the pitfalls that corrupt other men of similar intellect and ambition, and had the foresight to create institutions that will outlive him. Hopefully, he will inspire generations of Singaporeans to contribute to the country through a variety of ways - serving in government, developing private enterprise, and building a dynamic and inclusive civil society. Non-Singaporeans often say to me, "I hear Singapore is very clean and efficient." These days, I often respond, "Yes, but it's so much more than that." Mostly I'm referring to the glittering skyline, vibrant multi-cultural society and burgeoning appreciation of our history. But it truly is more than that - it is, and always will be, our home. We owe it to LKY, and to ourselves, to make it the best home it can be.
In the history of ideas, it is always fascinating to observe how certain notions gain traction and overcome opposition. Max Planck famously wrote, "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it." I've always found it a touch optimistic to assume that some form of objective truth always emerges victorious in the marketplace of ideas. We know that isn't the case, with discredited opinions often showing surprising and alarming resilience. Finance and economics are no exceptions to this phenomenon. For example, German hyperinflation is often cited as having led to Hitler's ascent to power, when in reality, it was deflation that brought the Nazis to power, as Matt O' Brien and Lars Christensen point out.
Sometimes marketing is important. Certain phrases seem to capture the public imagination, helping ideas spread, for better or worse. I'm often irked by the phrase "Lehman moment", which people often use casually to mean a tipping point in a crisis. Lehman, of course, filed for bankruptcy on Sep 15, 2008. While a massive event, it was just one of many in a significant chain of financial panic. I remember sitting with a fellow junior analyst on Sep 10 or so discussing the momentousness of Fannie and Freddie being put into conservatorship. The failure of the first TARP bill on Sep 29, 2008 also seems to be relatively forgotten in public memory, although that event coincides more closely with the real panic phase of the crisis (The S&P 500 was down about 3% in the 10 trading days between Lehman and the bill failure; it was down about 26% in the 10 trading days after the TARP bill failure). (See chart and data here - hardly conclusive, but worth noting).
But I suspect the real reason I find the phrase "Lehman moment" so chafing is because people often conflate the financial panic with the economic plunge, and ignore a slow Fed response to the crisis. It is surely too much to expect any institution to react perfectly to a crisis given the "fog of war", but I think it's still important to highlight the Fed's missteps. I've done so in a previous post, highlighting how Rick Mishkin's concerns were ignored by his FOMC colleagues.
Funnily, most criticism of Fed seems to be encapsulated in another popular phrase, "too low for too long" (TLFTL). TLFTL is of course is the notion that the Fed contributed to financial instability by pursuing an overly accommodating monetary policy prior to the crisis. I don't have a strong view on the matter, seeing arguments in both directions, but it's clear that current Fed policy-makers harbour worries about TLFTL. The Fed has made hawkish noises well in advance of any rate rises, leading to the infamous Taper Tantrum. And more recently, New York Fed President Bill Dudley made the following remarks in a speech:
"One significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels - for example, the 1-year nominal rate, 9 years forward is about 3 percent currently...If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher."
Let me note that (a) the context of this speech was a generally nuanced discussion of the real interest rate; (b) the speech is generally quite dovish in not wanting to adhere to a strict Taylor rule that would demand a higher Fed funds rate, and (c) Dudley's views do not, of course, represent the FOMC. But I found myself confused: Is the Fed now targeting long-term bond yields? The use of the word "conundrum" seems deliberate. Naturally, this brought to mind Greenspan's use of the word in testimony to Congress describing falling long-term rates despite an increase in the Fed funds rate. Greenspan and Bernanke seemed content before the crisis to explain away the conundrum with the "global savings glut" hypothesis. Post-crisis, however, Dudley, seems much less eager to use that argument. Dudley seems to be saying "The conundrum is back, but this time we'll act differently. TLFTL won't happen again."
Oddly, research by Daniel Thornton of the St. Louis Fed suggests that the relationship between Fed Funds and long-term yields had broken down by the 1980s. I must confess I don't have the econometric chops to evaluate this research fully. And even more importantly, perhaps I'm over-analyzing this. After all, policy-makers aren't known for inventive language, so Dudley might just be reverting to a familiar phrase. But if Thornton is right, it's disturbing for Dudley to focus on long-term bond yields. If the Fed is swayed by the price action of long-term bonds, combined with a lingering institutional sense of TLFTL guilt, I would be deeply concerned for the global economy and financial markets. I would also expect such a course of action to backfire spectacularly since long-term bond yields would probably decline if the Fed was too hasty in raising rates. But some bad ideas never seem to die - and as we've seen, some of those bad ideas can have painful repercussions for a very long time.
The case against active asset management, particularly of equity investments, has many prominent expositors. Warren Buffett, perhaps the greatest known exponent of active management, made the startling remark in 2014 that he wanted his 90% of his estate to be put into a low-cost S&P 500 index fund. A more comprehensive argument is proffered in Swedroe and Berkin's excellent "The Incredible Shrinking Alpha", which is a highly readable summary of the case against active management. Swedroe and Berkin (henceforth S&B) lay out a variety of arguments against active management, which I summarize as follows:
1) Many alpha-generating factors (such as value, small size, momentum and quality) have been identified, so they can now be harnessed more cheaply, and are effectively beta.
2) In a competitive financial environment, successful trading strategies self-destruct. If a clear anomaly is discovered, investors will seek to exploit it, eventually leading to its disappearance. Or to put it more poetically, Lee and Verbrugge write, "The efficient market theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world."
3) Alpha is a zero-sum game, meaning some investors must exploit the mistakes of others. This is becoming harder as (a) the growth of index funds drives down their costs, increasing their advantage over active funds, and creating a virtuous circle of size, lower fees and better performance; (b) the number of funds has grown, creating far more competition for alpha; (c) the "paradox of skill" means that today's active investors are better trained and have greater resources, making it harder to achieve outlier results; and (d) successful active management creates large inflows, making it difficult to replicate success.
Before proceeding, I must draw a distinction (as S&B do) between passive index funds and passive funds with systematic rules. To simplify matters, I'll refer to these as index funds and systematic funds respectively.
I'm extremely sympathetic to argument (1). Despite my background as an active investor, I'm quite willing to accept that passive funds with systematic rules can help investors in their search process and mitigate cognitive biases. But I'm far more cautious about index funds, which ironically are seen as simpler for the average investor to understand.
S&B themselves acknowledge the debt index funds owe to active managers: "Active managers play an important societal role - their actions determine security prices, which in turn determine how capital is allocated. And it is the competition for information that keeps markets highly efficient both in terms of information and capital allocation. Passive investors are "free riders." They receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, we don't want everyone to draw that conclusion." Essentially, index funds are derivatives of the skill of active managers and steadfastness of systematic funds. But derivatives, the ever quotable Buffett reminded us, are "financial weapons of mass destruction". The history of financial innovation seems to be strewn with examples of legitimate new tools taken to excessive lengths. We may one day think of the well-intentioned index fund in a similar fashion.
To explain this, I turn to Argument (2), which is broadly true, but occasionally wildly wrong. While markets are generally efficient in the medium term, it doesn't take much financial history to know that sharp periods of deviation from efficiency can occur. S&B appeal to the idea that markets are better information processors than individuals due to the aggregation of collective wisdom. Likening a skilled individual investor to tennis great Roger Federer, they write, "While the competition for Federer is other individual players, the competition for investment managers is the entire market. It would be as if each time Federer stepped on the court, he faced an opponent with Roddick's serve, Murray's backhand, Gonzalez's forehand, Nadal's baseline game, Stepanek's net game and Ferrer's speed." This is a good analogy with one problem: for all its supposed skill, we know that the market occasionally has the temperament of John McEnroe or Marat Safin. While we can agree on general market efficiency, we should not over-sell the principle. Indeed, we need active and systematic funds to act as "stabilizing speculators", to quote Milton Friedman.
This can be seen simply as a rebuttal of the neoclassical EMH model. A timely new paper by the IMF's Brad Jones summarizes current arguments for deviations from the EMH:
In similar fashion, we can raise some criticisms of index funds.
- Limits to learning: "Markets are particularly vulnerable to bubbles where there is a low level of financial literacy among participants, and common knowledge over the existence of a bubble is absent." (Jones) If investors are plowing money unthinkingly into index funds, they will have no anchor against market turbulence. This is a version of the Standing Ovation Problem, where agents act due to their own beliefs, but also out of mimicry and conformity. S&B make the following argument about active strategies: "When a strategy becomes popular, not only will it have low expected returns due to crowding, but the assets in it are now "weak hands" - the investors who tend to panic at the first sign of trouble. That leads to the worst returns occurring at the worst times, when the correlations of all risky assets move toward one." There is no reason this would not apply to index funds.
- Frictional limits to arbitrage: "Another source of friction capable of amplifying bubbles stems from the 'captive buying' of securities in momentum-biased market capitalization-weighted financial benchmarks...Importantly, the captive buying phenomena [sic] is unlikely to abate given the (passive) benchmark-tracking exchange traded product industry has expanded at a decade-long annual growth rate of more than 20 percent (to US$2.5 trillion), a much faster rate than for other relatively non-benchmark constrained investors."
- Institutional limits to arbitrage: As index funds become ever more entrenched in the financial mainstream, it may become increasingly difficult for managers to veer from benchmarks despite valuation concerns.
To be clear, I'm not saying that index funds are unambiguously bad or dangerous. Index funds allow investors to gain exposure to equity risk at a low cost. Like any other tool, however, they should be used with care, with a clear understanding of what they represent - an investor's claims on cash flows to an underlying equity piece. S&B have done a wonderful job in bringing together various strands of the case against active management. But investors should be wary of substituting one false god for another.
