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Post Indexes are NOT Portfolios (from Michael Frank)
Created by John Eipper on 03/31/21 5:28 PM

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Indexes are NOT Portfolios (from Michael Frank) (John Eipper, USA, 03/31/21 5:28 pm)

Michael Frank responds to Ric Mauricio (March 31st):

First of all, let's talk a bit about what we mean by "the market." The standard proxy at the moment is the S&P 500 index. Here are a few things to think about: the index is a list of the 500 "best stocks," this according to a group of nameless analysts at S&P. It's not a portfolio. It's a list. That's not a picayune point. A list has no cost. I could make up a list of stocks at any point in time; all it costs me is a piece of paper. To actually turn it into a portfolio not only requires investment capital, it requires transaction costs, custody costs, opportunity costs, and financing costs. So you're behind before you begin. The S&P index is market cap-weighted. Which means that the more a company is worth, the larger its representation. While it's not really clear why that would be a good idea, the effect is that the very biggest companies on the list have the greatest impact on its value. So you can play around with Viacom all you like. The twenty top companies in the S&P list account for 90% of the variance. And here's the tricky part: since it's just a list, the ordering changes with every tick. Today's top twenty can be costlessly replaced at any moment by tomorrow's top-twenty list. And S&P analysts can add or remove component stocks at any time. So the index investor is passively investing in an active list. This is why it's tough to "beat the market."

The expectation of market beaters is that performance of any outlier will eventually revert to the mean. Your bet on Viacom is based on the expectation that it will do exactly that. But what if it doesn't? You don't have to go to far to find a marquee company of yesterday that went permanently off the rails. GE for example. The management situation there wasn't clear to the general world for many years. If you had taken that bet in 2016, 2017, 2018, 2019 or even 2020, you would have lost your bankroll. It's done better so far in 2021, but so what? How long can you tolerate the downside? All you need is one mistake to ruin your portfolio. So its no surprise that it's tough to consistently beat the market. It's true that from time to time, even a dealer with a stacked deck can be beaten. But success won't happen with any consistency. The occasional bad play aside, time and repetition favors the dealer.

For me, the more interesting question is why tracking funds work. Because unlike an index, a tracking fund is a real portfolio. It has to rebalance daily, and customers continuously make deposits and withdrawals. All of which require stock transactions. So it pays commissions and spreads, custodial fees, marketing and advertising, accounting costs, makes regulatory filings, holds shareholder meetings, pays interest on uninvested balances, maintains capital reserves, and on and on. There is some advantage to scale, but most of these expenses are going to cost a small percentage of portfolio value that compounds every singe day. Given the many sources of friction, there should be either significant tracking error, sales loads, or expense ratio. The fact that these funds are close to zero in every expense category should raise an eyebrow. I think there are two components to their "secret sauce." The first is that for the last forty years, net inflows have been positive almost all the time. Which means that "new money' pays to keep the fund in balance. The other is stock lending, which is "free" income to the fund. The downside of lending is that it causes volatility in the money markets in bad times, and in good times it enables short bets against the fund's own shareholders.

JE comments:  Michael, I follow you up to the very end of your essay.  I understand the "new money" part, as this is how America's pensions have worked since ERISA in 1974, but what are "short bets against the fund's shareholders"?  Who shorts anything in good times?

Here's a tribute to secret sauce, and its Big Mac-inspired cousin, the special sauce. Is there a single American from my generation who doesn't know the full lyrics to the ditty?  Two all-beer patties, special sauce, lettuce, cheese...

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  • What is Stock Lending? From Michael Frank (John Eipper, USA 04/02/21 3:43 AM)

    Michael Frank writes:

    When commenting on my recent WAIS post, John E posed two questions: "What are 'short bets against the fund's shareholders'? And who shorts anything in good times?"

    Picture an index fund as a vault filled with stock. The stock is titled to the fund. While the investors have an undivided interest in the portfolio, they do not have direct ownership of the underlying stock. Consequently, the fund has some important rights that the participants don't. For example, the fund votes the proxies. The fund also has the right to lend securities from the pool, provided that any gains accrue to the benefit of the fund. The net lending fees can be used to defray cost, or perhaps paid to the investors as a little extra bonus. So let's take a closer look at stock lending.

    Stock lending and shorting go hand in hand...somewhere in the world, a speculator wants to bet against a stock. So they borrow the stock and immediately sell it. When the loaned stock is eventually called back, the speculator will then need to buy the stock in order to return it. The hope is that the stock will have dropped in price by that time, and the speculator can pocket the difference. Prospective borrowers are always lined up, because the fund is sitting on a vast pool of securities. There's always something in the vault that will be in demand by short sellers.

    Engaging in stock lending is facilitating short bets against the assets of the fund. It's tough to spin this as being in the best interests of the fund's customers. The argument for shorting is that it merely accelerates the inevitable. Since the fund is compelled by its charter to hold through thick and thin, no foul. Win or lose, the fund keeps the lending fees, and that reduces expense ratio. But even if shorting doesn't result in excess losses, the optics are terrible. Or would be if anyone took notice. The index fund lends because it's trying to track a frictionless list with an expensive portfolio. It needs to make the costs go away, because customers want to believe they're trading for "free." They'll keep the investors focused on low expense ratios and avoid the discussion of the impacts of stock loan.

    As to why anyone would short in good markets, it's because the price of any given stock is a random walk about the mean. So we can speculate that the price of Viacom is depressed because of some unusual selling activity, and will soon bounce back. We can just as rationally speculate that Tesla is grossly overpriced, because it's market cap exceeds that of all the other auto companies combined. Neither speculation necessarily involves a judgment about the quality of the companies, only a judgement that the market price is mismatched to the underlying trend. Shorting Tesla at the peak of its game may be completely rational, an example of value investing in reverse. (Don't mistake these hypotheticals for recommendations. And by way of full disclosure, I'm neither long nor short either company.)

    Let's finish this by examining how stock lending adds risk to the index investor, since it's not at all obvious. When the fund loans stock to a speculator, the borrower places collateral in trust with the lender, usually 105% of the amount borrowed. The fund takes this collateral, usually in the form of cash or treasuries, and invests it in the money market. So it not only collects fees on the loan, it makes interest on the collateral. Pretty cool, you're thinking. However, when the market crashes, this collateral becomes a frightful liability, because it has to be marked to market every single day. Whenever the price of the borrowed stock is falling, the fund's cash flow is working backwards: the lender actually has to repay the borrower's excess collateral. You may recall hearing that money funds "busted the buck" in 2008, this is a big reason why. The vicious demand for cash in a bear market disrupts the money markets in ways that aren't always orderly and predictable.

    When the market is deeply panicked, investors head for the doors. Index investors aren't immune to the siren call of cash. In order to fund redemptions, the fund has to sell stock, which means that it first needs to recall its loaned securities. Meanwhile, the shorts are living the dream--plunging stock prices and collateral being returned--and will delay returning shares if they can. Liquidity locks up, and the panic deepens, prompting more weak hands to sell. And that's why funds reserve the right to delay withdrawals.

    Against this sort of situation, index funds have effectively zero cash reserve. The thinking is that the investor's interest is always secured by the underlying stock. And that if the stock has been loaned away, it's still secured by IOU's from the borrowers and by collateral. So it's fine until it's not fine. One of the serious oversights following the meltdown is that not one asset manager has been identified as systemically important.

    I don't tell you these things to cause you to stuff your money under the mattress. I tell you these things because it's important to understand the things you can't control so that you can make good decisions about the things you do control.

    JE comments:  A most instructive explanation, Michael.  Thank you!  How many in WAISworld have contemplated what an index fund "does" with its existing portfolio?  Or for that matter, for short-sellers, do you wonder where the shares actually come from?  (I'm an amateur investor but a seasoned editor:  doesn't "short-seller" have to be hyphenated?  Otherwise we're implying that the investors are vertically challenged.  There's an analogy here with small-business owners.)

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    • More on Stock Lending, SPACs, NFTs (from Ric Mauricio) (John Eipper, USA 04/20/21 3:36 PM)
      Ric Mauricio writes:

      An excellent post on stock lending by Michael Frank (April 2nd). Allow me, if you may, to expand upon the subject.

      Index funds that primarily invest in large cap stocks benefit the least in lending out their securities due to the smaller spread between the bid and ask (a result of their increased liquidity in the markets), while the index funds that invest in mid cap or small cap stocks will benefit the most due to the larger spread, thus they are able to offset more of their expense ratios that would benefit their shareholders.

      Now, here's the rub. When an investor opens a brokerage account, they can open an account with margin capabilities. Now the brokerage firms that hold these accounts now have the privilege of lending out the investor's holdings and they don't even have to tell the investor. More so, unlike the index funds (or any fund, for that matter; doesn't have to be an index fund), the brokerage firm earns the lending fee, which they keep. Imagine, they are earning fees on securities they don't even own.

      Now, here's a further rub. Let's say the funds and brokerage firms lend the short sellers the securities, which, in turn the short sellers sell to another investor, who now holds the borrowed securities. Keep in mind that the short sellers no longer have the borrowed securities (otherwise they would be long and not short) but are obligated to buy back the borrowed securities if their brokerage calls them to do so. Now let's go once step further. The investor who purchased the borrowed securities from the short seller now has those securities in their "margin" account. Ha, the brokerage firm that administers their account can now lend those same securities to another short seller. This is why some companies can have a 125% short interest on their float, as we saw on one very visible stock in the last few months. A very dangerous game, if I may say. Does anyone remember October 1987? I couldn't even get a good quote from my market makers on the NYSE or NASDAQ.

      Now onto JEZZ. I recently received an email from a neophyte investor asking me what I thought of cryptocurrencies, the stock market in general (and the "fact" that it will now collapse along with the economy because of Biden), and gold. Oh my, my JEZZ antenna is tingling. Whenever I hear, read, or see these comments, it usually signals that you may not want to play in this game. I am sure that this neophyte investor is also wondering about SPACs and NFTs. SPACs (Special Purpose Acquisition Corporation) are created to bypass the normal IPO (Initial Public Offering) that are run through a consortium of brokerage firms. SPACs require less due diligence than IPOs, but save on costs because they don't have to share anything with the big bad greedy brokerage firms. But they do require greater due diligence on the investor's part because of this. By the way, due diligence by the brokerage firms does not guarantee that the company is a company that will do well. Remember the dot com bubble? All IPOs. Ouch!

      NFTs are Non Fungible Tokens. Note the word Fungi in the description. Well, some fungi aka mushrooms are poisonous, but most I fear are hallucinogenic. I mean, if I hold an original Honus Wagner card in my hands, or hang a Monet in my family room, I get that touchy feely tactile sensation. But something digital? I may be wrong, but sorry, I'll stick with companies and real estate that generate real revenues. Sure, I'll collect that coin or Pez, but at least I can enjoy it by holding it. By the way, the TV shows that sell collectible coins are scams... they are overpriced.

      As to John E's Pets.com, it was a matter of execution. Great idea, but terrible execution. Chewy had the same concept and is doing well. Takes a little research to separate the wheat from the chaff.

      One member in the gym commented to me that the reason he doesn't invest in the stock market is because of the volatility. Well, if you removed the volatility from the markets, you will end up with a return on investment equal to a CD, which underperforms inflation, so you will not be building a nest egg. Now there is the concept of market timing, to avoid the volatility. The issue of market timing is that most timing systems are based on moving averages. And the problem with moving averages is getting whipsawed. You sell when the security falls below a certain moving average and you buy when the security rises above a certain moving average. Many times you end up buying above your selling point, only to have to sell again, and buy again. Not only are you not getting anywhere or ending up where you would have been if you did nothing, but you incurred transaction costs (and yes, even though you may have zero commission cost, there is the spread between the bid and the ask prices) and possible tax consequences.

      Now what I found is that most investors tend to think too much and start ignoring or waiting on the signals. I like to embrace the volatility. I like to buy good companies when they are on sale. I execute the JEZZ system and buy when there's maximum pessimism and sell when there's maximum optimism. I also avoid, like my neophyte investor above, investments that are being highly touted (especially by the media and brokerage firms).

      JE comments:  Lots of acronyms here, but I'll start with most arcane:  JEZZ is the only known acronym in my honor, coined by our dear friend Ric Mauricio:  the John Eipper Zig-Zag approach (i.e., zag when others zig, investment-wise).  Ric also brings up one of the more bizarre "investment" vehicles of our age, the Non-Fungible Token/NFT.  The NPR radio show Marketplace did a segment on them recently.  In short, via NFT exchanges you can "buy" an digital token, such as the first-ever Tweet.  Who would pay good money for such nonsense?

      I'll change my mind when I can visit a Museum of NFTs.  Granted, the Henry Ford Museum in Dearborn, Michigan houses a test tube containing Thomas Edison's last breath.

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