Myron Scholes was on top of the world in 1997, having won the Nobel Prize in economics that year for his work in financial economics, work that he had applied in the real world in a wildly successful hedge fund, Long Term Capital Management. But just one year later, LTCM was saved from collapse only by a last-minute bailout that wiped out his equity (along with that of the other partners of the fund) and cast doubt on the value of his academic work.
Roger Lowenstein told the story of LTCM in his 2001 book “When Genius Failed“. I finally got around to reading this classic of the genre this year, and I’d say it is still well worth picking up. The story is well-told, and the lessons are timeless-
Beware hubris
Beware leverage
Bigger positions are harder to get out of (especially once everyone knows you are in trouble)
In a crisis, all correlations go to one
Past results don’t necessarily predict future performance
Sometimes things happen that are very different from anything that happened in your backtest window.
The book came out in 2001 but it presages the 07 financial crisis well- not about mortgage derivatives specifically, but the dangers of derivatives, leverage, using derivatives to avoid regulations restricting leverage, and over-relying on mathematical models of risk based on past behavior. If Fed had let LTCM fail, could we have avoided the next crisis? Perhaps so, as their counterparties (most major Wall Street banks) who got burned would have been more careful about the leverage and derivatives used by themselves and their counterparties, and regulators may have taken stronger stances on the same issues.
Perhaps some more recent well-contained blowups foreshadow the next big crisis in the same way, like FTX or SVB?
Last week we described a simple way to achieve roughly double investing returns on some asset class like an S&P 500 stock basket, or a narrow class of stocks such as semiconductors, or on some commodity like gold or oil. That way is to buy one of the many exchange-traded funds (ETFs) which use sophisticated derivatives to achieve a 2X or even 3X daily movement in their share prices, relative to the underlying asset. For instance, if the S&P 500 stocks move up by 2% on a given day, the SSO ETF will rise by 4%.
Of course, these leveraged funds will also go down two or three times as much. They also have a more subtle disadvantage, which is that when the markets go up and down a lot, they tend to lose value due to their daily reset mechanism.
In this post we describe a different way to achieve roughly double returns, which does not suffer from this volatility drag issue. This way is to buy long-dated deep in-the-money call options on a stock or a fund.
Say what? We have described how stock options work here and here. The reader who is unfamiliar with options should consult those prior articles.
A stock option is a contract to buy (if it is a call option) or to sell (if it is a put option) a given stock at some particular price (“strike price”), by some particular expiration date. Investors generally buy calls when they believe that the price of some stock or fund will go up. For a call option with a strike price far below the current market price of a stock, the market price of the option will move up and down essentially 1:1 with the market price of the stock.
For instance, as I write this the market price of Apple is about $230. Suppose I think Apple is going to go up by say $40 in the next six months. One way for me to capture this gain is to invest $230 in buying Apple stock. The alternative propose here is to instead of buying the stock itself, buy, say, a call option with a strike price of $115 and an expiration date of January 17, 2025. The current market price of this option is about $119.
Other things being equal, we expect that the market value of this call option will go up by $40 if Apple itself goes up by $40. But we have invested only $119, rather than $230, so our return on our investment is roughly double with the option than by buying the stock itself.
There is a subtle cost to this approach. At a stock price of $230 and a strike price of $115, the intrinsic value of this call option is $115. But we pay an extra $3 of extrinsic value when we buy the option for $118. This extrinsic value will gradually decay to zero over the next six months.
Thus, if Apple went up by $40 within the next month or so, we could turn around and sell this call option for nearly $40 more than our purchase price. But if we wait for six months before selling it, we would only net $37 (i.e., $40 minus $3). This is still fine, but it illustrates that there is a steady cost of holding such options. This annualized cost is about equal to or slightly higher than the prevailing short term interest rate (5% /year). This option pricing makes sense, since an alternative way to control this many shares would be to borrow money at current interest rates (5%) and use those borrowed funds to buy Apple shares. Options and futures pricing is generally rational, to make things like this equivalent, or else there would be easy arbitrage profits available.
As a side comment, the reason I am focusing on deep in the money calls here is that the extrinsic premium you pay in buying the call gets lower the further away the strike price is (i.e. deeper in the money) from the current stock price. A deeper in the money call does cost you more up front, but net net its dollar movements up and down more closely track (1:1) the movements of the underlying stock. So, if I am not trying to guess right on any market timing, but simply want to get the equivalent of holding the underlying stock but tying up less money to do so, I find buying a call that is about 50% in the money generally works well.
How I Use Deep in the Money Call Options
I consider the technology-oriented stock fund QQQ to be a core holding in my portfolio, so I would like to stay exposed to its movements. But I might as well do this on a 2X basis, to make better use of my funds. I do hold some of the 2X ETF QLD. But if we experience a lot of market volatility, the price of QLD will suffer, as explained in our previous post.
As a more conservative approach here, I recently bought a deep in the money call on the QQQ ETF. As usual, I went for a call option with a strike price roughly half of the market price, with an expiration date 6-12 months away. When this gets close to expiration (May-June next year), I will “roll” it forward, by selling my existing call option, and buying a new one dated yet another 6-12 months further out. This takes little work and little decision making. I will pay the equivalent of about 5% annualized cost on the decay of the extrinsic option premium, but I come ahead as long as QQQ goes up more than 5% per year.
This is a little more work than just holding the 2X QLD ETF, but it gives me a bit more peace of mind, knowing I have done what I can to smooth out some of the risk there. Of course, if QQQ plunges along with the markets in general, I will be looking at double the losses. For that reason, I am taking some of the money I am saving by using these leveraged approaches, and stashing it in safe money market funds. In theory that should give me “dry powder” for buying more stocks after they drop. In practice, I may be too frozen with fear to make such clever purchases. But at any rate, I should not be appreciably worse off for having used these leveraged investments (2X funds or deep in the money calls).
Disclaimer: As usual, nothing here should be considered advice to buy or sell any investment.
I ran across an article by Lyn Schwartzer on seeking Alpha last week, which I thought was insightful regarding investments. Here is my summary.
The article is Most Investments Are Bad. Here’s Why, And What To Do About It. The article’s first bullet point is “Historical data shows that the majority of investments, including bonds, stocks, and real estate, perform poorly.” Unpacking this, looking at various investment classes:
Bonds and Stocks
Investment-grade bonds typically pay interest rates just a little above inflation, so it’s not surprising that they have been mediocre investments over the long-term. The prices of long bonds (10 years or more maturity) tended to rise between about 1985 and 2020, as interest rates came steadily down, but that tailwind is pretty much over.
It has been known for years, e.g. from a study by Hendrik Bessembinder, that only a tiny fraction of stocks makes up the vast majority of returns in equity markets. I wrote about this a couple of years ago on this blog.:
The rise of the S&P is entirely due to huge gains by a tiny subset of stocks. The average stock actually loses money over both short and long time periods. … half of the U.S. stock market wealth creation [1926-2015] had come from a mere 0.33% of the listed companies… Out of some 26,000 listed companies, 86 of them (0.33%) provided 50% of the aggregate wealth creation, and the top 983 companies (4%) accounted for the full 100%. That means the other 25,000 companies netted out to zero return. Some gave positive returns, while most were net losers.
As investors, we of course want to know how to lock in on those few stocks that will perform well. I see two approaches here, not mentioned in the article. One is to be very good at analyzing the finances and market environments of companies, to be able to pick individual firms which will be able to grow their profits. Being lucky here probably helps, as well. An easier and very effective method is to simply invest in the S&P 500 index funds like SPY or VOO. Because these funds are weighted by stock capitalization, they inexorably increase their weighting of the more successful companies and dial down the unsuccessful companies. This dumb, automatic selection process is so effective that it is very difficult for any active stock-picking fund manager to beat the S&P 500 for any length of time.
What the article suggests in this regard is to focus on businesses that have “durable competitive advantages (network effects, powerful brands, intangible property, economies of scale, oligopoly participation, and so forth),” or to try to pick up decent/mediocre companies at a low price.
The big tech companies which are mainly listed on the NASDAQ exchange have these durable advantages, and indeed the QQQ fund which is comprised of the hundred largest stocks on the NASDAQ has far outpaced the broader-based S&P 500 fund over the last 10 or 20 years.
Real Estate
All of us suburbanites know that owning your own home has been one of the best investments you can make, over the past few decades. The article points out, however, that real estate in general has not been such a great performer. If your property is not located close to a thriving metropolitan area, where people want to live, it can be a dog. The article cites abandoned properties all around Detroit (“large once-expensive homes that are now rotting on parcels of land that nobody wants”), and notes, “In Japan, there are millions of abandoned countryside homes that are nearly free. Many of them are in beautiful and safe rural areas, and yet there is insufficient demand for them.”
And so, “Most real estate falls somewhere between those extremes. It performs decently, especially when considering that it can replace the owner’s rental income or be rented out for cashflows, but after maintenance and taxes are considered, its unlevered total return from price appreciation and cashflow generation net of maintenance leaves something to be desired relative to gold.”
Gold As a Reference
The article uses gold as, well, the gold standard of investing returns. The supply of gold creeps up roughly 1.5% per year, so after say 95 years there is four times as much physical gold as before. We find that an ounce of gold will buy more food or more manufactured goods than it did a century ago, but that is because our efficiency of producing such things has increased faster than the gold supply. On the other hand, “All government bonds have underperformed gold over the long run, and most unlevered real estate has underperformed gold as well.” Stocks in the broad U.S. market (most foreign stock markets did more poorly) greatly outperformed gold, but that is only accomplished by the top 4% of stocks. The other 96% of stocks as group did not generate any excess returns.
Owner-Operators versus Passive Investors
I am looking at these issues from the point of view of a passive investor – I have some extra cash that I want to plow into some investment, and have it return my original capital plus another say 10%/year, without me having to do extra work. It turns out that many companies, especially smaller ones, provide useful products to customers and they make enough profit to pay off the owner/operators and the employees, but not enough to reward outside passive investors, too. These companies serve an important role in society, but are not viable investment vehicles:
Being an owner-operator of a business, or a worker at a business, makes a lot of sense. However, the vast majority of businesses are not strong enough to provide good returns for outside passive investors after all expenses (including salaries) are considered.
Good returns for outside passive investors are reserved for only the best types of companies; companies that are so dominant and high-margin that even after paying all of their executives and workers, they have plenty of excess profits for outside passive investors. Although stocks from any sector can have these characteristics, Bessembinder’s research found that major outperformers were disproportionally concentrated in the technology, telecommunications, energy, and healthcare/pharmaceutical sectors. They are on the right side of an emerging tech trend, they have network effects, they have economies of scale, they have protected intangible property such as patents, or they are part of an oligopoly, and so forth.
Similarly, real estate (especially unlevered), works most easily when it is occupied or used by the owner. After all, you must live somewhere. Now, you can make money buying and renting/flipping properties, but that typically demands work on your part. You add value by fixing the tenant’s toilet or arranging for a plumber, or by scoping the market and identifying a promising property to buy, and by working to upgrade its kitchen. All this effort is not the same as just throwing money at some building as a passive investor, and walking away for five years.
Upping Returns via Leverage
This is a packed sentence: “Historically, a key way to turn mediocre investments into good investments has been to apply leverage. That’s not a recommendation; that’s a historical analysis, and it comes with survivorship bias.”
For example, banks have historically borrowed money (e.g. from their depositors) at lowish, short-term rates, and combined a lot of those funds with the bank corporate equity, to purchase and hold longer-term bonds that pay slightly higher rates. Banks are often levered (assets vs. equity) 10:1. This technique allows them to earn much higher returns on their equity than if they used their equity alone to buy bonds.
It is easy to leverage real estate. If you put 20% down and borrow the rest, bam, you are levered 5:1. Now if the value of your house goes up 6%/year while you are only paying 3% on your mortgage, the return on the actual cash (the 20% down) you put in becomes quite juicy: “After maintenance and recurring taxes, the majority of unlevered real estate, even when rented out for cashflows, doesn’t outperform gold. But unlike gold, 5-to-1 leverage makes real estate actually pretty good in many contexts, and historically allows it to outperform gold.”
Large corporations can leverage up by issuing relatively low-interest bonds: “They can borrow large amounts of money for decades at low interest rates, and use that capital to organically expand their business, buy smaller companies, or buy back their own shares. Either way, they are borrowing abundant fiat currency at low rates and using that capital to build or buy business equity, and they are arbitraging that spread for shareholders.”
Savvy firms like Warren Buffett’s Berkshire Hathaway take it a step further, by having controlling interests in insurance companies, and investing the low-cost “float” funds, as we described here. From the article:
Berkshire has also made a habit out of buying small and medium sized private businesses in full. Many of these smaller companies would have higher borrowing costs if they were independent. But Berkshire can buy a lot of them, and then issue corporate debt at the parent company level at much lower interest rates than any of them could issue on their own. So he can buy a lot of unlevered cashflow-producing small or medium-sized businesses, and turn them into a portfolio of businesses that are levered with Berkshire’s very low cost of capital.
Now other companies like Ares Management and Apollo are jumping onto this arbitrage bandwagon, buying up insurance companies to get access to their captive cash, to be used for investing.
Here is another rough example of the power of leverage. The unleveraged fund BKLN holds bank loans, and so does the closed end fund VVR. But VVR borrows money to add to the shareholders’ equity. There is more complication (discount to net asset value) with VVR which we will not go into, but the following 5-year chart of total returns (share price plus reinvested dividends) shows nearly triple the return for VVR, albeit with higher volatility:
The Changing Global Economic Landscape
The article closes with some summary observations and recommendations. The past 30-40 years have been marked by ever-decreasing interest rates, and by cooperation among nations and generally increasing globalization. It seems that these trends have broken and so what worked for the last four decades (buy stocks, shun gold) may not be as good going forward:
For equity and real estate investors, the key takeaways from this piece are 1) do not extrapolate the prior decades for a given investment and instead assess it with this context in mind, 2) try to emphasize the sectors [such as Big Tech] that Bessembinder identified as ones that disproportionally generate excess returns, and 3) look for companies that have locked in or are otherwise still able to play this arbitrage game going forward in a more difficult environment for it.
Additionally, hard monies [i.e. gold, silver] become a serious alternative once again in this context, and are worth serious consideration for a portfolio slice, because the hurdle rate for stocks to outperform them is high when there are not a lot of tailwinds at the backs of stocks.
Economist Writing Every Day 