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The Holiday Orgy of Wealth Destruction December 21, 2012

Posted by David Bookstaber in Finance, Transportation.

[S]omething like $13 billion a year, is what’s destroyed through gift giving in the U.S.

Joel Waldfogel wrote a whole book on this: Scroogenomics: Why You Shouldn’t Buy Presents for the Holidays. Add me to the list of those efficiency-lovers who disdain our suboptimal holiday customs.

If you want to give a person something of real value then give money. This gives the recipient maximum flexibility to meet their needs or wants. Purchasing a gift for them (including gift cards or items with gift receipts) simply takes something with maximal utility — money — and turns it into something with less utility.  The best you can hope for is to break even, and that occurs only if the recipient would have spent that money on that item at that time.

This guidance does not apply to gifts of time, expertise, or other devotion that aren’t fungible, and which may not even be available for purchase. Which may be where we lost our way: Money seems to be most stigmatized as a gift for occasions where consideration is more appropriate than value. In such cases cash is considered a cop-out — the refuge of scoundrels who don’t know or care enough about the recipient to find something meaningful. In past epochs when markets were less developed and efficient perhaps you could chance upon something at the bazaar that the recipient wouldn’t be able to readily acquire. But today if you could order the item online then you’re fooling yourself if you think that spending hours shopping to find it — on top of whatever time it took to earn the money to pay for it — is doing anyone a service.

Waldfogel has pointed out more systemic problems with holiday consumption patterns. For example: We have to carry excess capacity in our market infrastructure to sustain the holiday surge.  That capacity goes idle during the rest of the year.  The most efficient economy hums along at 100% utilization year-round.

This is not just a problem of gift-giving. Anyone who has tried to travel during holidays would have to agree that they are barbaric. Our goal as both individuals and as a society should be to smooth out surges, not to, for example, create “the busiest travel day of the year” by simultaneously crowding highways and airports, or overwhelming the same vacation destinations at the same time. These customs spawn deadweight surge capacity, though even that is invariably insufficient for peak demand.

Why do people voluntarily queue up for travel delays and long lines? It’s inefficient and unsafe. It’s insane.

Currency Arbitrage – Update April 9, 2012

Posted by David Bookstaber in Finance.
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The Canadian government has finally decided to stop minting pennies, something we should have done years ago.

Benchmarking Gold as an Inflation Hedge May 4, 2011

Posted by David Bookstaber in Finance.
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I have long derided “gold bugs” and others who claim precious metals are the best hedge against inflation. Here’s another way to look at it: You can buy dollar inflation protection from the U.S. Treasury in the form of TIPS. By shorting a suitable index of treasury bonds you can virtually strip out the interest-rate exposure of the TIPS, producing an investment with a government-guaranteed real return.

Now ignore all my other arguments against buying precious metals as a hedge against inflation. Even assuming the gold bugs’ best case scenario — that gold retains its real value — you still have to pay storage and transaction fees on the metal, so an investment in gold has at least a slightly negative real rate of return.

Except for the last few months TIPS have sold with positive real rates of return. So any rational gold bug (I know, oxymoron) should prefer the TIPS real-return strategy to investing in precious metals when TIPS offer positive real returns.

Granted, there are two risks associated with using the TIPS real-return strategy:

  1. The inflation measure used to calculate TIPS values might differ significantly from what you value. E.g., TIPS price food, clothing, and shelter, but you want to preserve your ability to buy silver bullets and steam engines.
  2. The U.S. government could actually default on its debt.

I’ve admitted in the past I wouldn’t be surprised to see the Treasury inflate its way out of debt. But in the dire situation that the Treasury actually defaults on its debt I believe you’re mistaken if you think gold bars are going to be any comfort. At that point you’re going to want stockpiles of real real value.

Public Pension Fund Update October 13, 2010

Posted by David Bookstaber in Finance, Pensions.
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Andrew Biggs estimated a $3 trillion shortfall in funding of state pension funds.  The WSJ reports that a study from the Kellogg School of Management has put the municipal shortfall at $574 billion.

Most governments use the expected rate of return on a pension fund’s assets—typically around 8%—to discount liabilities. Critics say this accounting method say liabilities should be discounted based on much lower Treasury note yields.

The higher the discount rate, the smaller the liability. Thus, lowering the discount rate could mean governments would have to contribute more to pension funds—with the money coming from taxpayers or employees.

One of the study’s authors, Kellogg professor Joshua Rauh, said in an interview that current accounting rules encourage pension funds to take investment risks and “taxpayers are bearing the burden of that risk.”

The Problem with Gold October 12, 2010

Posted by David Bookstaber in Finance.
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I’ve been a longtime critic of the fringe theory that gold is the best hedge against inflation and fiat currency risks.  Gold bugs revel in the relatively stable historical value of gold, and seek refuge in the fact that it has been a traditional store of value.  One problem I have pointed out is that its intrinsic value for industrial/practical purposes is not much higher than that of lead or copper.  Its stratospheric market value is entirely a function of (1) scarcity and (2) a speculative bubble.  I.e., it trades where it does because buyers believe that there will continue to be other buyers ready to pay these elevated prices.  If everybody decided one day that they would rather own platinum jewelry and hoard casks of single-malt whiskey as a hedge against inflation then the price and value of gold could collapse.

The other problem is that the supply of gold is not fixed.  True, the cost of mining and refining has historically been proportional to industrial capacity.  The last technological breakthrough in production came in the 19th century with the MacArthur-Forrest Process for extracting gold from low-grade ore.  But even barring another breakthrough in production the gold supply does increase with demand: The WSJ reports that the present surge in demand is leading to accelerating investment in mining.

Another Problem Inflation Would Help June 13, 2010

Posted by David Bookstaber in Economic Policy, Finance, Pensions.
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Public pension liabilities are the millstone dragging governments into the depths of a sea of red ink, deficits, and even bankruptcy. In a sad twist on this mixed metaphor, it is the pensioners who have managed to tie the millstone to the necks of the “little ones” — the younger generations working to pay increasing taxes to fund exorbitant pension benefits that were promised but never funded.

A few governments have discovered that they might be able to relieve a bit of the weight by reducing “cost-of-living adjustments” (COLA) — especially when those have historically had little or no relation to actual changes in the cost of living. For example, the WSJ notes that Colorado’s pension system had been granting a fixed 3.5% COLA every year to beneficiaries. If the COLA for defined-benefit pensions can be reduced below the rate of inflation, then inflation would gradually erode the real cost of the crushing unfunded pensions.

Of course, only the federal government has the power to inflate the dollar. But faced with a deluge states and municipalities sinking into insolvency under the weight of pension obligations, this would be yet another motive to nudge inflation higher.

(Predictably, pension beneficiaries are using every possible legal maneuver to prevent this. If only they had been so attentive when their unions and politicians were crafting extravagant future benefits to be borne by future generations.)

Flash Crash Lessons and Fixes May 31, 2010

Posted by David Bookstaber in Finance.
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In the aftermath of a crisis or accident crowds have an unfortunate tendency to build momentum behind overwrought and foolish responses. This is especially bad when the response is promulgated through government, which is ever capable of codifying bad ideas into law but only rarely manages to repeal them.

May 6 saw a “flash crash” in U.S. equity markets: a crisis that started sometime after 14:00 and was essentially over by the time the market closed at 16:00. It revealed a number of problems in the current market structure, and it also cost some market participants serious money. On May 6 we learned:

  1. Official market makers will not always make reasonable markets (see “stub quotes”)
  2. Beyond official market makers, there are significant liquidity providers who contribute to market efficiency but who can suddenly step away
  3. You should never blindly enter an order to trade without a limit price
  4. You should probably put limits on any standing stop orders, too
  5. At least one “sophisticated” market participant was using a poorly programmed algorithm (that would be the one that was sending orders to sell short stocks at a penny!)

These lessons were clear within a week of the flash crash. Yet in response the crowds seem to have concluded that the correct “fix” to these problems is to put “circuit breakers” on individual listings to halt trading on any stock that experiences a sudden change in price exceeding some threshold. This is a bad idea.

For one thing, stock-level circuit breakers could easily spark a contagion effect through the ETFs and index futures (which investors may use to protect themselves while a particularly large stock is halted). Furthermore, stock-level circuit breakers would actually tend to exacerbate volatility on stocks that begin to trade near any threshold that is set.

What’s the right response? Well, we do still need to look into whether market makers are fulfilling their obligations. But there’s a simple way to ensure that nobody will unwittingly lose money in a flash crash ever again: Require that all orders, at least from retail investors, include a limit price.

Currency Arbitrage – Update May 13, 2010

Posted by David Bookstaber in Finance, Uncategorized.
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Updating a topic of longstanding bemusement, the WSJ reports:

It costs the federal government up to nine cents to mint a nickel and almost two cents to make a penny.

Coinflation.com tracks the intrinsic (“melt”) value of metal coins.

A letter several years ago noted:

When the half-cent was abolished in 1857 it was worth more than eight cents in today’s currency. People then had no problem living in the following decades, during which the smallest unit of currency was worth more than our dime today. In fact, they persevered through that transition without the luxury of the many cashless means of electronic transaction we enjoy today (which, even after penny abolition, can preserve prices to the cent).

It’s silly that the U.S. continues to mint pennies and nickels. Just as silly is the fact that American businesses and consumers continue to carry them around for regular use in cash commerce.

Fundamental Indices February 25, 2010

Posted by David Bookstaber in Finance.
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Assuming stock prices have any noise (and they certainly do) a smoothed-price-weighted index will outperform a market-cap-weighted index. (See also here and here.) The downside of such a strategy (as with anything other than a market-cap-weighted index) are the tax and transaction costs of turnover, which may not outweigh the benefits.

Capital Gains and the Inflation Tax January 15, 2010

Posted by David Bookstaber in Economic Policy, Finance, Taxation.
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A great many opponents of the Federal Reserve Bank argue that fiat currencies, like the dollar issued by the Fed, have no inherent value and that we are at the mercy of a government-sanctioned currency monopoly to preserve our assets. I have explained that this is not accurate because nobody really has to hold dollars, and even if you are required by government or custom to use dollars for transactions there are small conversion costs from many other currencies and stores of value, so you can choose to minimize your exposure to value deflation resulting from the inflation of any particular currency.

However, even if you eliminate your exposure to dollars you are still harmed by dollar inflation because the government has imposed a “capital gains tax,” which the IRS has implemented essentially as a dollar inflation tax. The peril of fiat currencies is that debtors (like the states or state-sponsored entities that issue them) have an incentive to inflate their way out of debt. National debt becoming too onerous? Just print some more money to pay it off and enjoy the added benefit that this will inflate the currency (deflating the currency’s value) which reduces the real size of the remaining debt. Of course, if nobody uses your currency this will only go so far. But if you assess a tax on the basis of the value of your currency, as the U.S. government does, then it still gets you: As the dollar devalues all other assets appreciate in dollar terms. Call that appreciation a “capital gain” and tax it.

Doesn’t seem fair, does it?

Inflation Conspiracies January 6, 2010

Posted by David Bookstaber in Economic Policy, Finance, Taxation.

If you are a debtor, and your debts are denominated in dollars, then dollar inflation directly benefits you by reducing the real cost of your debt.  So imagine the moral hazard when one of the biggest dollar debtors — our government — happens to have the ability to inflate the dollar!  (Not to mention that, due to our tax code, dollar inflation is itself a tax that increases government revenue.)

Rick Bookstaber notes the political spin on this situation:

Suppose all the Good Guys (Joe Consumer and Homeowner) are loaded with debt, and suppose that this debt is payable to the Bad Guys (Rich People and Foreigners). What can you do about it? Oh, and also suppose that the debt is mostly in nominal terms. Answer: You inflate.

What will happen when politicians realize that they can surreptitiously redistribute wealth from capital owners to both the government and the indebted?  Since this is consistent with our government’s tendencies over the last century you may wonder why it’s not already happening.

For one thing, there is supposed to be a mechanism to prevent this:  The dollar’s supply is regulated by the Federal Reserve, which was supposed to be both (A) independent of the federal government, and (B) interested only in maintaining dollar stability.  However, some time ago they gave up on the latter point, with muddled pronouncements about balancing dollar stability with other economic objectives like employment.  And the last year or so has seen the evaporation of any semblance of Fed independence from the government.

So the institutional barriers that originally secured the dollar’s value are effectively gone.  The only other thing that holds back politically-motivated inflation is the fact that inflation only has the desired effect if it’s unexpected.  If the government came right out and said, “We’re going to 6% annual inflation in order to reduce our debts, increase our revenues, and help all the debtors who vote for us,” it wouldn’t work for long:  Owners of existing dollar-denominated debt would be hurt, but when the government went to expand or rollover its debt it would find lenders demanding annual rates at least 6% higher than they do now.  Likewise with individual borrowers.

In fact, if the dollar was abused too much people would probably stop lending in dollar terms at all: If you wanted a loan, repayment might be demanded in Euros, or barrels of oil, or ounces of bullion.  (Several of my recent investment posts deal with practical means of hedging against dollar inflation.)

And this is where the conspiracy comes in.  Bookstaber explains:

To do inflation right, you have to be a little sneaky. Especially if you don’t want your creditors feeling totally screwed and have them walk away the next time you need to borrow. Don’t announce it as a policy. Have it just happen. In fact, have it happen in spite of all of your best efforts to reign it in. So you need a controlled burn that looks like it is spontaneous. Who knows, maybe this idea actually is making the rounds.

Given the political inclinations of the current establishment it’s not hard to imagine.

Standardization Enhances Market Efficiency July 5, 2009

Posted by David Bookstaber in Finance, Markets, Regulation.
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Standardization is a public good.  So do we need government to promote it?

Standardization of products and specifications is invaluable to market efficiency.  For example, a standard “letter”-sized sheet of paper will fit in a standard envelope, or binder.  It is sold in “reams” of 500, making it easy to compare prices.  It can be used in almost any printer or scanner.  Imagine if each paper company manufactured proprietary paper dimensions to increase the likelihood that only their file cabinets and folders could keep their products organized?

Mechanical fasteners tend to be standardized.  Only a handful of screwdrivers are sufficient to adjust almost any screw.  What if you had to go to the manufacturer to buy a special set of tools for every individual product you wanted to repair?

Common languages, formats, and specifications are the backbone of the information markets, just as standardized shipping containers, roads, and vehicles are the backbone of our physical markets.

Unfortunately there are incentives for producers to secure rents by avoiding standards.  Inkjet printer manufacturers have proliferated proprietary ink cartridges in order to inhibit competition for replacements.  Most beverages are sold in standardized containers, but odd-sized bottles are an occasional ploy to make a product literally stand out from its competitors that can be tucked away in standard shelves.

Whenever the market wouldn’t overly penalize it, a manufacturer would prefer to create a specialized component that only it can economically manufacture instead of a standardized component that performs the same function but that is broadly and competitively produced.  I.e., unjustified specialization is an attempt to extract monopolistic rents from the market by avoiding competition.  However, unlike true monopoly, specialization is always suboptimal because it also avoids the economies of scale (in both production and use) that result from standardization.

What market forces resist specialization?  Only the ability of consumers to detect and properly incorporate the cost of specialization into their behavior.  But in the real world there is information and behavioral inertia that will always prevent markets from reaching optimal levels of standardization.  No consumer is equipped to analyze a product for specialized components, and determine where specialization was justified, or what the added cost of specialization will be over the life of the product.

What market forces promote standardization?  There is an upfront cost to be born in defining standards, and no individual consumer or producer has an incentive to make that investment.  Standardization is something of a public good.  Therefore, do we need the coercive hand of government to promote standardization to ensure the good functioning of markets?  I have wondered before whether we can rely on the gentle hand of non-governmental organizations to nudge markets to more optimal behavior.


The Proper Role of Government in the Free Market April 10, 2009

Posted by David Bookstaber in Finance, Markets, Regulation.
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Socialists have grabbed onto the (largely government-caused) financial market crisis of the last year as evidence that capitalism and free markets are inherently defective.  I believe this has been adequately debunked: government meddling in home finance and labor markets was not only a primary cause of recent crises, but subsequent “bailout” measures have only exacerbated problems that the free markets were equipped to most efficiently resolve.

Early in the crisis I addressed the limited but justifiable role government might play in the markets.  Amar Bhide has a good essay continuing this theme.  In particular he notes the government regulatory institutions that were already in place to deal with market crises:

Our government plays an important ameliorative role. Unemployment benefits stop major dislocations from creating the widespread hunger and homelessness experienced in the Great Depression. They also prevent the anxiety of more than 90% of the workforce that remains employed from turning into a panic.

Bankruptcy laws and courts facilitate the orderly unwinding of obligations that individuals and businesses can no longer meet or easily resolve through bilateral negotiations (as is often the case when a troubled business faces many creditors with different kinds of claims). A bankruptcy code that quickly salvages the greatest possible value from failure is crucial for our economic dynamism.

The Federal Deposit Insurance Corporation (FDIC) immediately assumes the liabilities of failed banks and then gradually disposes of their assets — a process that has ended the bank runs that used to trigger depressions until the 1930s. But beyond amelioration and providing the judicial (or in the case of the FDIC, quasi-judicial) procedures for reorganization, there is little more that the government can do to accelerate the unwinding and renewal necessary to put the economy back on an even keel.

Hedge Fund Reform Finally Pushed By Investors March 29, 2009

Posted by David Bookstaber in Finance.

Two years ago I detailed the misalignment of incentives in the standard hedge fund fee structure and concluded:

It is obvious that this needs to involve delayed vesting of performance fees.  Performance fees should be kept in escrow with a vesting period much longer than one calendar year.  [D]elayed vesting will keep [managers’] skin in the game even if they have a big drawdown.

Sadly, it took last year’s experience of enormous drawdowns and fund failures for the biggest investors to begin to demand this reform.  Finally Calpers, one of the biggest hedge fund investors, has had enough.  WSJ reports it has sent a memo to funds in which it invests outlining its expectations.

One area Calpers is focusing on includes performance fees. Typically they are collected at the end of each year, but Calpers instead wants fees spread out over several years. Calpers also wants clawbacks, which allow clients to recoup fees from previous profitable years after a period of poor performance.

And that’s not all.  In December I highlighted another major problem with traditional hedge funds: opacity.  I predicted major investors would begin to demand transparency into strategies and positions.  This is also part of the Calpers request:

Calpers also wants money managers to disclose every security held in a fund. “The only issue that keeps hedge funds from providing security transparency is their lack of cooperation,” Calpers spokeswoman Pat Macht said in an interview Friday.

Judy Shelton, the Wall Street Journal’s Gold Bug March 20, 2009

Posted by David Bookstaber in Finance.
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Judy Shelton published a book 15 years ago advocating a return to gold-backed currencies.  She has few credentials and no online presence or ongoing academic involvement that I have been able to find.  But almost every month for the last year the Wall Street Journal’s editorial page has printed an essay by her that, ultimately, argues for a return to gold-backed currency:

As I have previously written, concerns about dollar integrity are certainly justified: The central bank and government are colluding to try to print their way out of a financial crisis.  And as our government compounds its borrowing it will face increasing incentives to simply inflate its way out of debt.  Today’s WSJ has an article about the increasing money supply showing that money creation has been more than offset to this point by the Great Delevering of this crisis.  No inflation will occur until the former overcomes the latter, although the more the money supply is built up in advance of that tipping point the greater the risk of a “snap” inflation that the Fed cannot easily unwind.

I agree that nobody with significant assets should count on the dollar or any other fiat currency to conserve value.  But as I have explained before, the point Shelton and other gold-fanatics gloss over is that nobody has to: While fiat currencies are generally the most liquid and fungible medium of exchange, markets offer many practical means of avoiding currency valuation risk.

Derivatives markets for currencies and interest rates are enormous and efficient, allowing any particular currency risk to be priced and neutralized.  Dollar inflation insurance can be purchased explicitly through inflation-protected bonds: Another article today quotes a bond fund manager reiterating my view that TIPS are currently bargain insurance.

Currency owners are also free to store and trade value using many other media — including gold.  For small fees, an individual can convert dollars into gold, and then back into any currency to facilitate trade.

Governments cannot be counted on for “sound money,” but capitalism has given us efficient means to create it ourselves.

Iceland March 6, 2009

Posted by David Bookstaber in Finance.
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Michael Lewis has a thoroughly fascinating description of a tiny, inbred island nation that managed to blow a huge bubble in the global markets (that just recently burst in spectacular fashion).

Back away from the Icelandic economy and you can’t help but notice something really strange about it: the people … are presented with two mainly horrible ways to earn a living: trawler fishing and aluminum smelting. There are, of course, a few jobs in Iceland that any refined, educated person might like to do. Certifying the nonexistence of elves, for instance. … But not nearly so many as the place needs, given its talent for turning cod into Ph.D.’s.

Read the entire thing.

Shareholders Face Tyranny of the Majority Too February 7, 2009

Posted by David Bookstaber in Finance, Government.
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Democracy suffers from a fundamental flaw known as the Tyranny of the Majority.  Carl Icahn today points out that corporations, as currently organized, suffer the same hazard: A large shareholder (an institutional investor in his example) can vote for management that acts in its special interest, and counter to the general interests of other shareholders.

[M]any institutions have a vested interest in supporting [particular corporate] managements. It is the management that decides where to allocate their company’s pension plans and 401(k) funds. And while there are institutions that do care about shareholder rights, unfortunately there are others that are loath to vote against the very managements that give them valuable mandates to manage billions of dollars.

In practice it doesn’t even take a literal majority to win votes: When the potential gains for a special interest far outweigh the costs to everyone else, the majority often does not muster enough energy to cast the scrutiny and opposition necessary to defeat the special interest.  (I previously called this phenomenon the Tyranny of Special Interests.)

Let Profit Guide Government Spending (and Bailouts) January 23, 2009

Posted by David Bookstaber in Economic Policy, Energy, Finance, Government Spending.

How can we avoid turning a government bailout into a political boondoggle?  As I suggested yesterday on Rick Bookstaber’s blog:

The expectation of profit is the only way to prevent politics from perverting market interventions. If government can interfere at times and in ways in which it does not expect to make a profit then you may as well tell special interests to grab their sacks and form a line to have them filled with taxpayer money.

But if there is a true financial crisis then, by definition, there is an objective opportunity for a liquidity provider to realize excess profits in the distressed markets.

If we insist that government can only intervene in times and ways in which it can expect a long-run profit (without abusing its power to “change the facts on the ground”), then we take most of the political hazard out of the equation. Instead of the current debate we see — are Paulson and Frank just funneling tax revenue to their friends and cronies in NYC? — the only debate would be on whether the long-run fair value of assets being bought by the government is clearly above the price at which the government can buy them.

(Profit is the same criterion I previously proposed for managing the Strategic Petroleum Reserve.)

Trust Funds of the World: Unite! December 29, 2008

Posted by David Bookstaber in Economic Policy, Finance, Pensions.

State and local government pension funds contain several trillion dollars in assets.  I have previously highlighted the significant hazards of public defined-benefit pensions, but I neglected to note a particularly terrifying one: Many of these funds are overseen by novices.

Some time ago the WSJ reported on Stanford’s “Committee on Fund Governance” forum report:

Some recommendations are so elementary they seem hardly worth stating. One suggests trustees educate themselves about their duties. “A fund should identify and disclose its leadership structure,” reads another. Many funds profess to follow these and other principles. Yet Mr. Clapman says his group found “a very large percentage [of funds] are not doing one or more of” the report’s recommendations.

There is no reason for every trust to get involved in investment management when the only thing that varies between funds is how much they owe and when.  They’re all trying to do the same thing — and all for public benefit — so there should be huge economies of scale to merging their funds.  A number of UK endowments realized this and joined a cooperative called OXIP (Oxford Investment Partners).  Vanguard is a cooperative investment company in the US that offers similar outsourcing of investment management.

But outsourcing investment management does not go far enough.  Any ongoing exposure by taxpayers to pension obligations is dangerous and unjustifiable. Taxpayers, shareholders, creditors, and employees have no business carrying the risk that pensions will be underfunded or mismanaged, or that investments will not perform as projected.

Defined-benefit pensions should buy annuities to cover their liabilities. For a small fee this transfers the risks of longevity, investment performance, and investment management to third an insurance company which is formed and regulated precisely to handle those risks.  (As an added bonus, buying annuities from an insurance company makes it nearly impossible to obscure the present value of pension benefits being promised.)

The status quo is outrageous: The same government officials who offer pension benefits to government employees get to pick the models that predict how long pensioners will live and how well investments will perform.  These perennially optimistic projections make the pension obligations look cheap, but some taxpayer money is still taken and put in a trust fund to invest against those obligations.  Of course, these funds are under government control, which means they are constantly threatened with political abuse.  Meanwhile, the trustees are not investment experts, so they have to pay for a staff, which has to pay for consultants, which recommend funds of funds, which invest in individual funds.  Every party in this investment management chain collects fees, but none of them guarantees anything.  So when the trust fund comes up short the taxpayers have to cough up yet more money to cover pensions promised long ago, and nobody is held to account for the failure of the trust to meet its obligations.

If governments were not allowed to run their own pension fund scam, they could still offer defined-benefit pensions: They would just have to provide them by purchasing (up front) annuities from insurance companies.

The End of Black-Box Investment Funds December 17, 2008

Posted by David Bookstaber in Finance.
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Foster & Young’s paper “The Hedge Fund Game” is getting renewed attention.  I covered this earlier this year, but the more the game unwinds the more astonished I am that so many people failed to see the hazards inherent in the traditional hedge fund structure, namely:

  1. Lack of transparency into strategies and actual investment activity
  2. Ability to trade derivative securities
  3. Steep incentives for short-term gains

Together these characteristics make it impossible to determine whether a successful hedge fund is (plausibly) generating alpha — which is what investors believe when they commit money — or whether it is instead gambling on a portfolio with strong negative skewness — i.e., one that makes steady positive returns with high probability, but with low probability eventually “blows up,” taking massive losses.

Alpha is worth paying for, and there any number of ways sophisticated managers can generate returns on capital that are uncorrelated to the market and that have attractive expected return characteristics — arbitrage; market making; astutely harvesting premiums on liquidity, information, and risk.  The problem Foster & Young rigorously demonstrate is that a “mimic” can either intentionally or naively (e.g., Victor Niederhoffer) sell options to create a negatively skewed stream of returns that with high probability is hard to distinguish from positive alpha … until it suffers a catastrophic loss.

Naturally, the more you pump up returns by these methods, the higher the probability that the fund will crash. As previously shown, however, the probability of crashing is not all that high on an annual basis for excess returns that look very impressive. Furthermore, if you are risk-averse, there is a simple way to spread the risk: Just start several funds under different names and run them in parallel, using independent piggybacking strategies. The probability is high that at least one of them will survive, yielding performance fees that make up for poor results at some or all of the others.

Under the traditional three rules of the hedge fund game it is so easy for an fund manager to make a fortune as a mimic that hedge fund investors who did not break one of those rules should have simply assumed they were paying someone else to gamble with their money.  Indeed, it is hard to distinguish the results of many hedge fund investors from that scenario.

Foster & Young go one step further with a formal argument that there is no plausible incentive scheme that can mitigate this hazard.  They summarize:

Essentially, we have shown that the industry is vulnerable to entry by managers who have no particular skill but whose lack of ability is difficult to detect, based solely on their track records. In short, the hedge fund industry has a potential “lemon” problem. This term was coined by economist George Akerlof to describe the used-car market, where sellers tend to have much more information about the reliability of their cars than do potential buyers. This leads buyers to insist on lower prices to compensate for their risk. But then the owners of cars that actually are of high quality will withdraw them from the market, which means that the remaining cars will be, on average, even riskier. The result is a downward spiral in prices and a situation where no one can sell a car at a reasonable price.

I.e., breaking the third rule of the game is not enough to remove the hazard!  If you break the second rule you are effectively restricting the game to the mutual fund world, where it is much more difficult to create portfolios with large skewness.  (Granted, mutual funds have seen their own gaming in the form of “actively managed funds,” which have proven to be nothing more than a means for investors to pay higher fees to gamble on managers, who in aggregate have been unable to outperform the market indices investors can buy more cheaply.)

When it comes down to it, the only practical way to remove the hazard from the hedge fund industry is to break the first rule.  Foster & Young conclude,

[T]he root of the problem is lack of transparency. Skilled managers need to find a way to distinguish themselves from the low-quality entrants. Here the analogy with the used-car market provides some clues to the solution. Just as a buyer can hire a mechanic to look under the hood of a possible purchase, so hedge fund managers may have to allow professional intermediaries (acting on behalf of potential investors) to have extensive access to their books and trading strategies, not just once but on an ongoing basis. Alternatively, individual fund managers may find it advantageous to operate under the umbrella of a large organization that can guarantee the product, just as the owner of a used car may prefer to sell it through a dealer rather than try to market it himself.