Friday, May 28, 2010

Asset Allocation for Fun and Profit

In my previous post I suggested that commodities speculation was a poor idea and not a good use of retirement funds. But the fact that I think it's a lousy idea doesn't explain why a brokerage like Fidelity would suggest such a strategy. To understand why commodities are being promoted as an "asset class" (and Fidelity is neither the only nor the first brokerage to start pedaling commodities as an asset class) you have to look at what half a century of efficient market theory has done to investing.

Modern Portfolio Theory

To understand anything a brokerage ever does, you have to understand at least the basics of Modern Portfolio Theory. Here's the short version, it's not very complicated.
  • Markets are efficient - you can't beat them because they already "know" everything you do. So picking stocks isn't going to get you a better retirement fund. You might as well buy an index of all stocks and keep the fees low.
  • If two separate markets have low covariance (that is, they go to hell at different times) that's the only free lunch you'll ever see. By investing in both, you can limit how far down your portfolio tanks. If stocks and bonds go to hell at different times, then at any one time maybe only some of your money is hosed.
  • Combine these and you realize something strange: the important question is what types of things you invest in (the "asset class") and in what ratio. The important thing is not the details. In other words, your ratio of stocks to bonds matters a lot, but which stocks you buy doesn't.
MPT dominates the "buy" side of investing (e.g. the institutions that manage people's retirement money) in a huge way. "Lifecycle" funds are just funds that adjust the ratio of stocks vs. bonds as you get older, based on MPT.

Go Off the Cliff With the Herd

There's another boot-print from quantitative finance on the face of investment management. Since the market is "efficient", it's not the place of your investment adviser to try to beat the market. And MPT provides cover for this. If I am in my 30s and my adviser suggests that I should be 70% in stocks, and then the stock market loses half of its value, that's not negligence, incompetence, or a breach of fiduciary duty. MPT says that I have to be heavily in stocks for my risk-return profile. And that investment adviser has a certain amount of cover: pretty much every other investment adviser has suggested the same thing, so "no one could have known".

Unfortunately, MPT strikes me as a difficult approach to long-term investing. MPT "works" based on the historical long term (or sort-of-long-term) relationships between asset classes. But because everyone now uses MPT, the "good ideas" that MPT suggests may not be so good any more since those ideas move markets.

(Put another way: if everyone piles into stocks, the return on stocks isn't going to be very good. But MPT says we should pile into stocks because past returns were good. We saw the bull market of the 80s, we piled in, and in the process we guarantee that we won't have a bull market like that again.)

Look, Fees!

Now here's the problem with MPT from the perspective of a brokerage: it makes it really hard to make any money. If I manage your money, I make my return based on a fee (usually a percent of assets under management for a mutual fund or ETF). But the actual asset classes that I can manage keep moving toward lower fee structures. For example, Van Guard's total market return stock index fund (TMI - this is the ETF I use quite frequently) has an expense ratio of 0.07%. And now (finally) you can get bond index funds with low expense ratios too. BND, another Van Guard ETF has an expense ratio of 0.12%. (This is a huge improvement over the 0.5% you'd pay on bond mutual funds; with only a few percentage of return a 0.5% fee was a huge chunk out of returns.)

Fidelity seems to now be charging me $8 to buy/sell ETFs. So let's review: Fidelity takes $8 to make my purchase every now and then, and Van Guard gets between 0.12% and 0.07& in fees. How does anyone make any money off of this?

To make matters worse, Fidelity can't (and no one else can) credibly come to me and say "you should pay more for this proprietary product" - some magic 'beat the market fund' or the advice to 'stay out of stocks'. MPT says that they can't beat the market and they shouldn't be messing with my asset allocation. So no way to add value there. (Heck, if they did come up with a product that went against MPT and it tanked, they'd probably get sued.)

And now we have enough pieces to understand my cynical view of commodities investing. Currently "buy side" money management companies have only two asset classes to sell (stocks and bonds) and the margins on those products have gotten very, very low. But if they can invent a new "asset class", investors would nearly have a mandate to buy it (due to MPT) and while the market is fresh and new, there's still a hope of raking in fees.

A quick screen of commodities ETFs shows expense ratios from 0.3 to over 1%. And ETFs are usually the cheapest investment vehicle available to retail investors.

In summary: it has become to save for retirement very cheaply. Commodities investing isn't necessarily a good idea, but because it's a new market it's still profitable. Investment advisers have to make the case that commodities are an "asset class" in order to justify selling commodities funds to investors.

In all of this discussion I have not mentioned gold. That is going to have to be the last (and separate) part of this rant. Buying oil, coal, grain, or copper - that's commodities speculation. But buying gold is something very different, and in my opinion, even more loopy.

Thursday, May 27, 2010

You Too Can Be a Commodities Speculator

If there is a magic to investing, I believe it is this: on average, investing is a game of chance where you win more often than you lose. This is because underlying a quality investment is a business idea or a use of resources that produces more than it consumes. If I provide capital to a business (whether buying stocks or bonds) that business might be able to grow and add value. Thus my investment isn't just a zero sum speculation where I hope to guess better than others - it's a chance to create something new.

Of course, that's not really true if you are a commodities speculator. I received this note from Fidelity the other day. The idea is pretty simple: if you're a long term investor, you should have some exposure not just to stocks and bonds but also to commodities.

The problem: it's a terrible idea. Commodities "investing" isn't investing at all. It is speculation. You are making a bet that commodities will be more expensive in the future. That's the only way you will make any money. A business borrows money and pays interest because they believe that what they can do with the money will generate more cash flow than the interest payments. A business issues equity (stocks) because they believe that they will be able to retain earnings (that is, make a profit that will belong to the stock holders) or pay dividends to the stock holders.

What kind of a dividend does a barrel of oil pay? What interest rate do you get on a bushel of wheat? Here's a hint: zero. Commodities "investing" strips away the "investment" part of investing and leaves only the speculative component.


The traditional way to invest in a commodity is to hoard it - that is, to buy a claim on production of that commodity and then sell it later when it's worth more. It's hoarding, plain and simple. When you buy a bond, your capital is temporarily useful to someone else - you are making available capital more plentiful. When you hoard a commodity, you're simply taking away from everyone else.

And this brings me to my first major concern about commodities speculation via hoarding: it bites back. If enough people hoard enough of a commodity, the price rises (through increased demand) and one or two things happen:
  1. Suppliers of the commodity increase production, anticipating support form higher prices. (E.g. oil producers start drilling more wells.) This increases supply, which will lower the value of your hoard.
  2. Real users of the commodity find alternatives to using the commodity. (E.g. cars become more fuel efficient.) This lowers demand, which will lower the value of your hoard.
In other words, the value of your commodity is influenced in the wrong direction by your interference in the market. And most commodities markets are quite small relative to capital markets; when investors all decide they want to buy oil, they overwhelm the actual users of oil.

It Takes Two To Contango

The second concern is the cost of hoarding. Even if you do want to hoard, how do you do it? Most ETFs don't stash commodities in a warehouse because that's expensive. Instead they buy forward contracts, which require them to buy the commodity in the future. When delivery time comes around, they then sell the commodity (at the price for the commodity with immediate delivery, called the "spot price") and buy a new future, "rolling" the commodity contract. By doing this forever, the ETF can claim a commodity without ever having the real materials show up.

The problem with this is that the price of the futures contract and the "spot price"aren't the same. If the spot price is lower than the futures price, the market is in "contango". Let's review that transaction. Once a month the ETF sells at the spot price, buys at the future price and...uh oh. We're losing money with every transaction and making it up in volume.

There are some good reasons for commodities markets to be in contango - in particular, if a ton of investment money is trying to roll futures contracts, the increased demand for futures and supply of spot is going to drive the market into contango. The gain or loss is called "roll yield" and it's been negative for a while, since so many "investors" decided to speculate in oil a few years ago. Even if your speculation is correct, making the profit minus roll yield might not be much fun.

A Lot To Pay For Stock

Fidelity suggests a series of mutual funds with exposure to commodities. The letter specifically quotes the manager of the Fidelity Global Commodity Stock Fund (FFGCX). This fund hasn't been around long enough to look at its correlation and beta, but there is one statistic that sticks out to me immediately: the 1.42% expense ratio. (Fidelity has been generous to subsidize the fund to get the expense ratio down to only 1.25%. Great.)

The other funds have expense ratios of about 0.9%, betas greater than 1 (meaning they are more volatile than the whole stock market) and R-squared of about 0.5 (meaning that when your stocks tank, they're going to tank a bit too).

Basically you're paying higher fees to buy volatile stocks that will still take a hit when the market tanks.

In summary, investing in commodities:
  • Isn't really investing at all.
  • By its very nature forces down the commodity you are investing in.
  • Costs real money just to speculate.
  • Is still expensive when done via corporate exposure (which isn't even a direct play on a particular commodity).
But I don't think that any of this has to do with why Fidelity is advocating commodities. I'll explain what's really going on here in another post.

Monday, May 10, 2010

It's Supposed To Be "Exciting"

Bloggers seem concerned about the temporary 1000 point drop in the Dow last week.

I don't think this price move changes anything. But it does remind us of something:

If you need your money back tomorrow (or really any time in the next few years) stocks are the wrong investment vehicle.

The day-to-day price of stocks is anchored in...well, it's not anchored at all. Stocks can fall indefinitely.

So my argument is this: any investment scenarios that are no longer appropriate for stocks (now that we "know" that the market is highly volatile) were never appropriate in the first place.

Having a 30-year time horizon for stocks implies that you can wait out the kind of excitement we're seeing.

Tuesday, May 04, 2010

The Limits of Imagination


BP just couldn't imagine that their equipment could catastrophically fail and dump 200,000 barrels of oil a day into the gulf.

Citigroup just couldn't imagine that their super-senior CDOs might lose value.

From now on, I am not going to free up the memory I allocate. I just can't imagine X-Plane running out of memory.