Friday, September 13, 2019

Austria's 100 year bond.

If you create a bond with a 2% coupon in a world where interest rates are 0.9%, you can bet that that bond is going to be very very volatile. 

Case in point - Austria's 100 year bond that matures in 2117.  (note: register for the economist and you can view a few articles for free).

My quick calculations show that this bond has a duration of about 56.  That's pretty high!  I'd be interested to know whether investors are buying this a straight bet on interest rates or whether they are using it as part of a portfolio.  You wouldn't need much of this bond to tilt the duration of your portfolio higher.

Here are my excel computations, with the predicted price change using duration alone (which is not terribly accurate in this case).  For bonus points - explain why this is the case...

Monday, June 10, 2019

Why stocks are good hedges for inflation.

I was quoted yesterday in the Wall Street Journal on why stocks are good hedges for inflation.
Article is here:

Quoting from the article:
The reason stocks are a decent inflation hedge is because corporate earnings grow faster when inflation is higher, and grow more slowly when inflation is lower, according to Richard Warr, a finance professor at North Carolina State University. Consider the growth rate of corporate earnings over all 10-year periods since 1871, according to data compiled by Yale University finance professor (and Nobel laureate) Robert Shiller. The volatility of those growth rates was 21% less on an inflation-adjusted basis than it was on a nominal basis, which Prof. Warr says is a good indication of the extent to which equities are able to hedge inflation.
To be sure, Prof. Warr adds, higher inflation does reduce the present value of the otherwise higher future earnings. But these two effects should more or less cancel each other out over time.
Prof. Warr acknowledges that, over shorter periods of a year or two, stocks often suffer when inflation heats up. His research suggests that is because many investors are guilty of what economists refer to as “inflation illusion.” That is, they focus only on the reduction in the present value of future earnings to which inflation leads, while ignoring the tendency for nominal earnings to grow faster when inflation is higher. So when inflation spikes upward, they sell stocks.
Since the inflation illusion is irrational, it is difficult to predict whether investors will be guilty of it the next time inflation heats up. But Prof. Warr says that if they do and their selling causes the stock market to drop, investors should treat it as a buying opportunity."

Thursday, January 17, 2019

Bogle and the genius of indexing.

Jack Bogle passed away this week and the investing world lost one of the most important figures in modern history.   Bogle's contribution to investing is simple but of profound importance.  He showed that an index fund, run entirely passively, could outperform most actively managed funds in the long run. 

I've long been a very strong proponent of indexing.  I've posted heavily on the topic here in this blog, but a quick recap of why indexing is so brilliant is probably in order.

In any given year (ignoring costs), about 50% of all active equity managers will beat the market, while 50% or so will trail the market.   This has to be the case.  It cannot be the case that the majority of equity managers beat the market, because the market is largely actively managed.  Simply put - there has to be winners and losers. 

In reality however, more than 50% of active managers trail the market because of trading costs and fees.  These costs can easily be 1-3% or more per year, enough to cause a significant drag on performance.  Bogle realized that if you just bought "the market" and didn't trade and didn't spend money on active management, you could reduce the total costs to a nearly trivial amount, less that 1/10 of a percent.   The simple outcome of this strategy is that the "indexed" fund will beat more than 50% of all active funds in a given year, and in the long run will beat most active funds.

You might be thinking, surely 1 or 2 percent isn't that much?   Well, consider an investor with a million dollars: 1% is $10,000 per year every year.  This is a significant performance drag.

Or consider if you take $1,000 and compound for 40 years at 8% you'll end up with about $21,724.  But if you compound only at 7%, just 1% less per year, your original $1,000 will only grow to $14,974.   The 8% investment is worth 45% more than the 7% investment. 

This is why, in the long run, indexing always wins.  It's why I personally am 97% indexed and why I strongly advocate it for all investors (including pension funds).

And this is Bogle's legacy.  He's enabled many ordinary investors to be much wealthier than they would have bee had they stuck with active managers.

As Mark Hulbert says:
"... he bet his entire career and his mutual-fund firm on the notion that the vast majority of active fund managers would be unable to beat a simple index fund. And there was hardly a single calendar year since 1976, when he created the Vanguard 500 Index Fund in which he was wrong."

Wednesday, October 31, 2018

IBM to buy Redhat.

An interesting deal.  IBM has a strong presence in this area, and of course Redhat is a Raleigh based company.   Details of the deal are here:

A back of the envelope analysis suggests that there's about $7bn in merger gains.

GE cuts dividends

Dividend cuts are quite rare and even rarer for a stallwart stock like GE.  But yesterday, GE cut it's dividend to a penny a share.

There wasn't much of a price reaction, the stock had been on a downward trend, but the dividend cut certainly didn't help.

A dividend cut signaled that GE is struggling, but I don't think that was news to anyone.  Even an analyst upgrade didn't help the stock price.

A lower dividend payout means that the company can retain more cash and invest in growth, but as basic finance theory would state, dividend policy should be largely irrelevant in firm value.

Thursday, January 11, 2018

Do pro-diversity policies lead to greater corporate innovation?

That's the question that we (myself, Roger Mayer of NC State and Jing Zhao at Portland State) recently studied in a paper that's forthcoming in the finance journal: Financial Management.

The answer is YES.   We found that firms that promote diversity have more new products, more patents and more influential patents.

You can read the paper here:

Here's the summary on the NC State news page.

And here's a nice write up on WUNC radio's website, together with some additional links that talk about the benefit of diversity in teams.

Wednesday, September 13, 2017

Bitcoin is a fraud says JPM boss

It should be remembered however, that this is coming from the CEO of the company that received a $12bn government bailout.

The problem with Bitcoin, as I see it, is that it is a commodity and not a currency.   It's largely like gold, except that gold has some use outside of being a means of speculation.

While I wouldn't be surprised if Bitcoin remains marginalized, what is more important is the role that blockchain technology will play in finance in the future.

Tuesday, August 1, 2017

The stupidest thing you can do with your money.

In a recent episode, the Freakanomics podcast talks about why you should index.  It's a great show - check it out:

Interestingly, Anthony Scaramucci is interviewed as being an advocate of active management (he's the guy who ended up being fired by Trump after 10 days).  Scaramucci's arguments for active management don't really make any sense - they are based on the idea that financial advisors and active management are the same thing.   They are not.  A good financial advisor who understands indexing is well worth the fees.  Such an advisor can help in tax planning, retirement, college savings etc and provide real value to clients without ever selling an actively managed product.

Thursday, July 20, 2017

Why 8.5% is delusional

I am quoted today in an article on about the Connecticut pension fund return assumptions.  The article is here:

So why is an 8.5% return assumption delusional?

It's pretty simply really.  Assume that your fund is 50% bonds, 50% stocks.  Currently 10-year Treasuries are yielding about 2.3%.  Let's round that up to say 3% to be generous.  Assume an equity risk premium of 5%, and equities will return about 8%.  So our hypothetical pension fund is going to earn:

             50% bonds + 50% equities = 0.5*3 + 0.5*8 = 5.5%

Even with a tweaking the bonds to 4%, and using a risk premium of say 6%, you are looking at:

            0.5*4 + 0.5*10 = 7%

I think 7% is still pretty optimistic, but if we use today's numbers, 8.5% implies stock returns of:

            8.5 = 0.5*3 + 0.5*X

Solve for X, ... go ahead, I'll wait.

           X = 14%.

So stocks would need to return 14% on average, implying an 11% equity risk premium.  That's why it's easy to say that 8.5% or even 8% is delusional.

But just labelling something delusional doesn't really help anyone, and I appreciate this.   Unfortunately to ensure a pension fund is fully funded, and meets a realistic return goal, either contributions have to increase, or payouts have to decrease.  Both are hard choices and there's no easy fix.  Just setting a high return merely kicks the can down the road.

Saturday, July 15, 2017

Will fee cutting hurt the pension fund?

In an article yesterday in the News and Observer (, David Ranii explores whether fee cutting by the pension fund might hurt future returns.

It's a good article, I was interviewed for it, and I recommend that you read it.  I would, however, like to add a small comment/clarification with regard to my comments within the article.

While I strongly support attempts by the pension fund to reduce fees, this has to be done in a sensible manner.  When high cost equity managers are liquidated, the proceeds should be put into an equivalent low cost index fund.  What the pension fund has been doing is to put these proceeds into cash and fixed income.  In the article, I am quoted as noting that this action will likely result in lower returns for the pension fund going forward.  

The article incorrectly portrays me as in conflict with critics of the pension fund's strategy.  This is inaccurate.  I fully agree that cutting fees by firing equity managers and then putting the proceeds into cash is a bad idea.  This will hurt future returns.