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World Association of International Studies

PAX, LUX ET VERITAS SINCE 1965
Post Jump Market Risk
Created by John Eipper on 02/11/21 3:05 PM

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Jump Market Risk (Jordi Molins, -Spain, 02/11/21 3:05 pm)

In relation to the recent discussion on GameStop, my conclusion is the market is pricing a serious amount of gap/jump risk.

The argument is as follows:

A clever and professionally accomplished friend described to me a financial strategy he is developing, as follows:

He has reached agreements with Hedge Funds he knows well. The Hedge Fund trades in his managed account (so no Madoff risks). Instead of paying the Hedge Fund the typical 20% of profits, he pays them 50%. In exchange, the Hedge Fund must agree to cover the first 10% of any losses arising from their strategy.

My friend has a good risk management system, and he is able to cut the positions of the Hedge Fund when the portfolio is down, say, 8%.

The portfolio never goes below -10%, so the investor never records a loss. Granted, the upside is quite limited, at 3% to 4% per year. But in Europe, many insurance companies may be highly interested in a product that yields in the low single digits, but with a high probability of no loss.

Apparently, this structuring "beats the market." However, and this is my main argument, we all know that by shifting risk one way or another, the market remains efficient. It is true that Jim Simons has been able to beat the market, but not by simply shifting risk.

A reasonable conclusion is that this strategy is able to "hide risk under the rug." And this hidden risk is gap/jump risk, since no risk management system can cut the positions in a portfolio if there is a sudden, unexpected move down in the markets.

My hunch is that the structuring of this strategy is telling us, in a convoluted way, that markets are already expecting some kind of gap/jump risks in the future.

JE comments:  I'm learning a lot this week about investments.  Do I understand correctly that jump risk is simply the risk of a stock going down massively and quickly?  A vertiginous rise in a stock is never a problem, unless you've shorted it.

Jordi, do you believe this "first 10% of loss on us" strategy going to catch on?  The downside is, you're giving up 30% of your profits.  And the true pain is not in the first 10% of your loss, but in the next ten or twenty (or more) percent.


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  • Ric Mauricio on Short Selling, Fiduciary Oath (John Eipper, USA 02/23/21 3:23 AM)
    Ric Mauricio writes:

    I must admit, I have been trying to get my head around Jordi Molins' friend's Hedge Fund strategy. (See Jordi's post of February 11th.)


    According to the strategy, if the hedge fund portfolio drops 10%, Jordi's friend is able to exit the portfolio with no loss. The hedge fund covers that loss. Considering that hedge fund portfolios are not insured against losses by any governmental entity, this puts the onus on the full faith and credit of the hedge fund itself. Since hedge funds cannot issue new currency, this faith is as ethereal as well, a belief in religions. But let's look at the positive side. Since the "upside is quite limited, at 3% to 4% per year," I am assuming that since the average hedge fund historic return is 7.3%, that this return of 3 to 4% is 50% of that historic return. OK, considering that the real global inflation rate historically has fluctuated between 3 to 4%, that gives us a return of possibly zero percent. And with the possibility of the hedge fund not being able to cover that 10% loss, I am thinking, "what's the point?" Kind of reminds me of Jesus' Parables of the Talents, where the third servant was so fearful that he just buries the bag of talents. By the way, talents were currencies of silver, but the word "talents" is apropos. There are those who do not fully utilize their "talents," no matter how great or small they are, because of fear.


    Yes, I could see where insurance companies would be highly interested in a product that yields in the low single digits. What insurance companies do is sell these products to consumers, then turn around with the premium proceeds and invest in real estate (Buffett invested in companies or stocks) gaining a conservative 10 to 12% return. I'd love to earn 6 to 9% per annum on other people's money. What's the calculated return on utilizing other people's money to invest? Infinite?


    I have only shorted one stock in my 50+ years of investing. Why? The risk/reward ratio is not good. For example, I shorted a stock that IPOd at 15, with the first trade at 26 (you should have seen how many rookie brokers placed market orders to buy at the IPO, only to get executed at 26; whoo, the market makers were giddy as they bagged an $11 profit per share at the outset on these foolish brokers/investors). I shorted the stock at 29. Here was the risk/reward scenario: I could bag a $29 profit per share if the stock went to zero or I could lose $100/$200 per share if it kept on climbing. But you see, before the company IPOd, I was at my local ToysRUs store. I noticed the company's Teddy Ruxpin end cap display. And I watched as kids stopped, pushed a button and watched the Teddy Ruxpin bear talk. Did they buy? No. Hmmm. Interesting. Then came Christmas time, and I noticed that a lady brought the Teddy Ruxpin bear back to the store because it didn't work. The ToysRUs staffer brought out new batteries. Didn't work. Brought out more Teddy Ruxpins. Didn't work. Finally, the 10th one worked. Oh boy, is that company in trouble. So thus my first and only short: Worlds of Wonder.


    The hedge funds who shorted GameStop know the risks. Do I feel sorry for them? Not a bit. But those who bought to ramp up the price, well, to them it is gambling. It's an all-in bet, but without the skill of professional poker players who calculate the odds. Thus those amateurs late to the game lost big time as well. Hopefully, they'll learn. One person who will never learn, unfortunately, is the guy who killed himself. I think he read his account wrong. Sad.


    Having been in the financial industry, I have a bone to pick. Fiduciary duty and its application. The brokerage industry continues to fight the application of this duty to its brokers and analysts. Why? Fiduciary duty is a legal obligation of the highest degree for one party to act in the best interest of another. The party charged with the obligation is the fiduciary, or one entrusted with the care of property or money. As a CFP (and now, retired, so CFP Emeritus), I was bound by the Fiduciary Oath. Before then, even as a stockbroker, I believed in practicing this duty. Even in other capacities, and as a person, I believe we should treat others with highest regard.


    In accounting, we have the Sarbanes Oxley rules, which costs millions of dollars and thousands of pages to enforce. To me, that was the biggest waste of resources. Everything in the SOX rulebooks can be summarized in one sentence: Do the right thing. Unfortunately, the brokerage business relies on salespeople, humorously called Financial Advisors, to bring in the funds. Today, as Chief Investment Advisor for my Family Office, I have a fiduciary duty to my family, my kids, my grandkids and subsequent generations to do the right thing. But then, when my kids were growing up, wasn't I always trying to do the right thing for them? When I meet other people, do I not try to do the best for them? As a personal trainer, I subscribe to the medical Hippocratic Oath of doing no harm. And as Jesus taught, "Love your neighbors."


    JE comments:  Do the right thing.  Add to this the Golden Rule, and you've created the perfect society.  The rub we've observed over the last few millennia is in the implementation.


    Ric, can you tell us more about the Fiduciary Oath?  Is it literally something that Certified Financial Planners are "sworn in" with, like physicians with the Hippocratic version?  Finance people (except you, of course) are famously cavalier with other people's money, but this impression may be inaccurate.  What grade would you give the majority of CFPs?


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    • Europeans are Happy with a 3 to 4% Return (Jordi Molins, -Spain 02/23/21 1:29 PM)
      Ric Mauricio (February 23rd) is right that Hedge Funds yield, on the long term, about 7.3%. Since the Hedge Fund manager of the strategy we have been discussing so far is able to get 50% of the (positive) returns, this means the investor in such a strategy gets about 3 to 4% per year.

      The flipside is the Hedge Fund manager needs to post 10% of the assets he will manage as cash in an escrow account. The strategy will be able to draw from that escrow account, if there are losses. So, the 10% guarantee is real.


      From conversations with Americans, I see a return of 3 to 4% per year is considered to be irrelevant. However, in Europe investors are desperate to get any guaranteed return (even 0%! cash yields -0.5% nowadays). An insurance company that is able to get, with a high probability, a 3 to 4% return (and with a low capital consumption in Solvency II, due to the 10% guarantee) will find this deal to be an exceptional one. The problem with this strategy, according to my friend, is that it looks "too good to be true."


      As discussed, this strategy has its own merits. For sure, it is a better strategy than most. However, it reveals that the market is pricing a non-negligible amount of gap risk. I believe this is mostly unappreciated, so far.


      Finally, there is a second unappreciated risk: if the gap risk materializes, the Hedge Funds that now are willing to risk 10% of cash to get the 50% upside could become reluctant to continue to do so. As a consequence, the strategy would cease to be practicable, and my friend should return capital to investors.


      JE comments:  Jordi, you mention Europe's negative .5% yield on cash.  WAISer Bert Westbrook once tried to explain this phenomenon to me (while sitting on this very couch!), but I confess I still don't follow.  What is the incentive to pay someone to hold your cash?  US 10-year Treasuries yield 1.37%, and a coffee can in the back yard at least gives you a guaranteed zero.

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    • Certified Financial Planners and the Fiduciary Oath (from Ric Mauricio) (John Eipper, USA 02/27/21 7:16 AM)

      Ric Mauricio writes:



      To answer John E's question, yes, CFPs are "sworn in" to having a fiduciary duty to their clients. All of the CFPs within my sphere adhere to this, but since it is a small sample base, I cannot make a judgment whether other CFPs adhere to the Fiduciary Code.


      However, my experience with stockbrokers is a much larger group. Out of 300 or so "non CFPs," I can state that I could only trust five of them. Let me share a story. One day I was in my cubicle with one of my clients when a broker came rushing over as he was on a cold call. He said he knows why stock mutual funds go up and down, but asked why would bond mutual funds fluctuate? My client asked if he could answer. He explained why. As the broker walked away, he said to me, "I'm sure glad you're my broker." But this wasn't as bad as another broker told a prospective client that a bond mutual fund couldn't go below $15. Another broker and I asked her how she could say this. Her response was that it IPOd at $15 so it couldn't go below that. Ouch!


      As a consultant to the many high tech, biotech and VC firms here in Silicon Valley, I have encountered many managers who have no idea how to manage people. They just pretend that they know what they're doing. They cover up their insufficiencies and insecurities by bullying their employees. Known as the "Fixer," I am often brought in to fix the problems.


      One of my team members asked why I don't scream at her and make her feel small when she makes a mistake. I told her it's because I'm perfect and I never make mistakes.


      Let's change subjects for a moment. A question for Jordi Molins: if the hedge fund drops 20% (eg. a company that recently purchased bitcoin dropped 50% in a few days), then the client loses 10%. Still seems to be a lopsided risk vs. reward deal. I think that most insurance contracts pay that 3 to 4%, with no risk to interest or principal.


      JE comments:  Ric the Fixer!  This sounds ominous, but WAISers know what a sweetie you are.  The impression I've always had of traditional brokers is that they have their own interests in mind, not yours.  This is probably an oversimplification, but it's also the basis for the Charles Schwab model of the 1970s, which has been imitated everywhere:  the best manager of your money is...you.

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