Thought Bubbles from the Deep

[DeepState]

The broker owns the shares. I've never understood how that really works, presumably there are protections somewhere along the line to stop a rogue broker using your shares as security for his holiday home in the Hamptons.

It is exactly this issue which was my immediate suspicion. IB could be cheap because it is lending your stock out and generating a heap of income which it keeps for itself. Hence you are exchanging cheap brokerage etc, for credit risk.

Except...on review, it looks like the assets are held in a nominee custodian in trust, whether in an associated company or not. And, they don't seem to lend your stock out unless you let them. Westpac On-line is the same, yet they can't come close to the brokerage levels, for example.

There just has to be something that explains this gap and I'm not comfortable with not knowing. Maybe they have the most super-efficient platform or something. Whatever. What is it?

 

[McLovin]

It is exactly this issue which was my immediate suspicion. IB could be cheap because it is lending your stock out and generating a heap of income which it keeps for itself. Hence you are exchanging cheap brokerage etc, for credit risk.

Except...on review, it looks like the assets are held in a nominee custodian in trust, whether in an associated company or not. And, they don't seem to lend your stock out unless you let them. Westpac On-line is the same, yet they can't come close to the brokerage levels, for example.

There just has to be something that explains this gap and I'm not comfortable with not knowing. Maybe they have the most super-efficient platform or something. Whatever. What is it?

On first sweep it looks like they've got a pretty big margin lending biz.

As of December 31, 2015 and December 31, 2014, approximately $17.0 billion and $17.1 billion, respectively, of customer margin loans were outstanding.

They don't pay seem to pay anything on deposits for most currencies, so even with their bargain basement margin lending rates they're making a very nice margin. I guess you need to decide if you're being adequately compensated for that risk.

 

[skc]

It is exactly this issue which was my immediate suspicion. IB could be cheap because it is lending your stock out and generating a heap of income which it keeps for itself. Hence you are exchanging cheap brokerage etc, for credit risk.

Except...on review, it looks like the assets are held in a nominee custodian in trust, whether in an associated company or not. And, they don't seem to lend your stock out unless you let them. Westpac On-line is the same, yet they can't come close to the brokerage levels, for example.

There just has to be something that explains this gap and I'm not comfortable with not knowing. Maybe they have the most super-efficient platform or something. Whatever. What is it?

I think all these stuff about counterparty risk will really be tested when a broker goes belly up. I went through MF Global and I am not at all interested in counterparty risk if I could avoid it.

Here are 2 articles on the stuff that happens behind the scene in MF Global that I doubt most customers were aware of.. and MF Global was for some reason one of the 8 treasury dealers (or whatever it was called).

http://www.zerohedge.com/contribute...t-2b-and-central-bank-couldnt-see-bankruptcy-

http://rogermontgomery.com/hyper-what/

Australian clients of MF Global eventually got the majority of money back. CFD clients got ~95% but it took 2 years (~50% after 1 year). And this is within Australia locally.

 

[kid hustlr]

DS are you stil around?

Would love to hear your thoughts on the current outlook. This whole concept of negative yield bonds has me confused - I don't understand why anyone would buy negative yielding paper - is the economy in that much trouble?

If it is, what do we do? Does negative interest rates infer gold is now a positive carry instrument?

 

[DeepState]

DS are you stil around?

Would love to hear your thoughts on the current outlook. This whole concept of negative yield bonds has me confused - I don't understand why anyone would buy negative yielding paper - is the economy in that much trouble?

If it is, what do we do? Does negative interest rates infer gold is now a positive carry instrument?

Hi KH

I am still around. Just a whole lot less voluminous and doing some investment-related things which are taking up a lot of time lately.

Negative yields are something I thought was impossible to sustain. Up until this era, they occurred for very short periods during major banking crises. What do I know?

We now have over USD 10tr of issued bonds trading with negative yields. Most of this is government, some of it is corporate.

I'm with you. What a ridiculous concept to be paid to borrow. Why would anyone lend on that basis?

Yet, here are some of the reasons:
- The returns on other assets are worse (eg. you might think that equities, property etc. will record poor risk adjusted returns)
- Holding cash is more expensive (you need to guard it, stop it from rotting, insure it...)
- Inflation will be very low or even negative, giving acceptable real returns, even if low by historical standards
- risk weights on government bonds are zero for major banks and this encourages them to hold liquidity here are they try to repair their balance sheets slowly
- it is the result of deliberate distortion by central banks to make asset prices so high that, eventually, investors move to invest in real production like building new factories or otherwise encourage companies which are already doing this to expand further.
- government debt growth is now slower than it had been and reducing as a share of GDP. For high quality credit, it means that supply is not growing as fast as demand. This pushes yields down. This argument is offset by decumulation of reserves in China and Saudi Arabia.

However, it's not all working as might have been hoped although it probably would have been much worse without this support. Movement to the real economy has not been progressing as much as might have been hoped.

There are at least two key reasons which have been put forward for this:
1. The world is so awash with debt that key components of the economy just won't take on any more debt.
2. Things look so ridiculous that people use cash as an asset. Normally, cash is used for transactional purposes for the most part. In this world, people don't want to invest because it all looks so silly. Thus they hold cash (and other near cash stuff).

Gold is now positive, relative, carry.

The economy appears to be recovering in terms of employment, GDP and less so on inflation although this figure is positive for the most part. Central Banks are very uptight on the inflation figures because the Keynesian beliefs they hold dear suggest that people will not spend enough if they think inflation is low or will go negative. Yet much of the reason behind low inflation is due to commodity prices or things like steel. Outside of that, it looks mostly ok.

There is so much which is weird. The most obvious implication is that the risk premium for holding long dated bonds is probably not sufficient to justify holding much of them (I own no foreign government bonds). Further, if bonds blow out, equity won't survive so well (I have protection in place and risk budget the exposure to equities quite tightly). There are other things which become relatively more interesting to consider for an investor. These are known as alternative betas. I have been adding these to my arrangements and have one or two more to go.

 

[kid hustlr]

Great as always DS and I feel I'm now at a point where I actually understand most of what you are saying.

Why I like your posts is that you have an economic understanding but you've clearly run money. Its the run money part I like.

So I'll keep digging.

As I stand back and I think well I can't buy bonds, and equities risk/reward don't look great - where do I turn to put my (small) hard earned? Australian property looks as bad as bonds to me also so the options become scarce quickly.

Perhaps some buy+hold equities? Perhaps some alternate options you suggest and I agree good mean reversion or momentum type strategies would (should?) outperform buy+hold. I'm still left with plenty to allocate though.

Gold is an option for some of it but what's the best way to play them? Etf's? Stocks? The XGD is up crazy numbers in the past year can I jump on now?

Seems to me I have two options:
1. I'm stuck running a standard 60/40 with some strategy exposure on the equity side and oveepriced bonds just hoping the past is the future and the strategies hold up - this feels wrong.

2. I keep some in equities put some under the mattress and the rest in gold and hope the world falls over - this also feels wrong.

Don't mean to clog your thread but conceptually it just seems super difficult right now to build a plan. Happy for this post to be moved should it not fit the theme of thread or I'm the only one thinking these things.

Regardless please do post more, Im sure I'm not the only one thinking that!

 

[DeepState]

Great as always DS and I feel I'm now at a point where I actually understand most of what you are saying.

Why I like your posts is that you have an economic understanding but you've clearly run money. Its the run money part I like.

So I'll keep digging.

As I stand back and I think well I can't buy bonds, and equities risk/reward don't look great - where do I turn to put my (small) hard earned? Australian property looks as bad as bonds to me also so the options become scarce quickly.

Perhaps some buy+hold equities? Perhaps some alternate options you suggest and I agree good mean reversion or momentum type strategies would (should?) outperform buy+hold. I'm still left with plenty to allocate though.

Gold is an option for some of it but what's the best way to play them? Etf's? Stocks? The XGD is up crazy numbers in the past year can I jump on now?

Seems to me I have two options:
1. I'm stuck running a standard 60/40 with some strategy exposure on the equity side and oveepriced bonds just hoping the past is the future and the strategies hold up - this feels wrong.

2. I keep some in equities put some under the mattress and the rest in gold and hope the world falls over - this also feels wrong.

Don't mean to clog your thread but conceptually it just seems super difficult right now to build a plan. Happy for this post to be moved should it not fit the theme of thread or I'm the only one thinking these things.

Regardless please do post more, Im sure I'm not the only one thinking that!

It's been a real struggle for me as well. I am so struck by how hard it is to generate a real return now. My hopes/plans(?) for investment returns are remarkably modest. Yet even they seem precarious.

I feel that I know this much when forming a plan:

1. No matter what you hope to earn, the governing factors are knowing what you cannot afford to lose and making sure that this does not occur.

2. There is a difference between solvency risk and risk tolerance. Solvency is actually not being able to have enough money in the long run. Risk tolerance is the ability to survive the journey. Both are important and necessary to consider.

3. The belief that we can discern what assets will go up or down in the next three years, say, is already a big statement. Trying to rank their relative merits or make even more finessed predictions that equities will to 7.5% and emerging markets will do 8.2% seem quite tenuous to me....despite widespread currency. Yes, I did this. Still do.

4. Entering the markets on the basis that you are smarter than the rest is a big statement. I'd rather position on things where I have some form of natural advantage for the heavy lifting. Trading is not something I do for a living. It clearly works for others. Yet others may need to trade in order to have any chance of meeting their goals as more passive premia will assure insolvency. Nothing to lose.

5. If you don't know what is going to happen for sure and you have a bunch of ideas that seem sensible and are willing to back, then put them together in a way which meets 2. in the best possible way. Although not to the taste of many, I am very heavily diversified, not in just what I own, but in the way that I hold them. When you look into that, what you find are really a small number of ideas that drive the whole show. Maybe six in my case. Equity risk premium, for example, is one idea that I am happy to expose myself to. That idea is expressed via exposures to many thousands of stocks (I hold around 80 Australian shares directly and overseas developed and emerging markets shares largely via ETFs).

Gold. If you don't think you'll actually need the physical asset in your hands, then a Gold Receipt might be worth considering. PMGOLD, for example. Means you don't have to buy a safe, insure it... If you want to secure a production profit against that then gold companies are essentially a real option on the price of gold. You do need to value them. Gold miners perform in a very strange way so their evaluation can be challenging. There are risks in any choice you could make. I own some gold via PMGOLD. It is a small holding of a couple of percent which I see as an alternative to holding exposures to fiat currencies in part. In other words, I see gold as a currency (and also a hedge in extreme situations) and think it has a place in a way which is similar to saying that I have exposure to JPY and think that is reasonable too.

This thread has no defined topic so please feel free to express your views and invite comment from myself or others who may be passing by.

 

[Triathlete]

It's been a real struggle for me as well. I am so struck by how hard it is to generate a real return now. My hopes/plans(?) for investment returns are remarkably modest. Yet even they seem precarious.

I feel that I know this much when forming a plan:

1. No matter what you hope to earn, the governing factors are knowing what you cannot afford to lose and making sure that this does not occur.

That idea is expressed via exposures to many thousands of stocks (I hold around 80 Australian shares directly and overseas developed and emerging markets shares largely via ETFs).


This thread has no defined topic so please feel free to express your views and invite comment from myself or others who may be passing by.

Hi DS,

I would be interested to know how you go about keeping on top of your 80 Direct Australian share holdings. Seems like a lot of work.

What is your average hold time with your holdings?

Do you base your decisions on Fundamentals, Technicals or a combination of both??

I would also be interested in knowing with these holding over the last say 12-18 months how many went up in price, sideways and down in price.

What type of return are you aiming for on average???

Cheers
Triathlete

 

[DeepState]

Hi DS,

I would be interested to know how you go about keeping on top of your 80 Direct Australian share holdings. Seems like a lot of work.

What is your average hold time with your holdings?

Do you base your decisions on Fundamentals, Technicals or a combination of both??

I would also be interested in knowing with these holding over the last say 12-18 months how many went up in price, sideways and down in price.

What type of return are you aiming for on average???

Cheers
Triathlete

Most of the positioning is motivated by a systematic approach. It is an implementation of simple smart beta concepts and also the mispricing of franking credits. The portfolio is risk managed based on fundamentals like industry membership and also statistical properties. Other measures are observed. There is a fair bit going on. In terms of technicals, there is no crossing of MA lines, VWA, EWs etc. motivating any position. However, I do care about the historical pattern of returns in other ways and also for risk management. Even with the systematic approach as a base, nothing hits the market unless I am satisfied that the idea makes sense given what it is trying to achieve. In some cases, like MVF-AU, I will deep dive and any insights here are blended into the portfolio in a way which treats these insights as if they were another systematic source of return. Rebalancing occurs every month of two, whenever I get around to it. It's not that sensitive to this. Around 50 lines will trade each time, not all of which are complete closures or fresh opens.

What I do is not completely straight-forward. Given your questions are about the AEQ component, I suppose I could say that my concern is performance vs ASX 200 in this part and that it beats cash in general. Runs with a tracking error of 3% per annum. Aim to get about 2-3% per annum outperformance. Holding period is about a year. All going fine. Don't really know the stock level hit rate. Not something I watch. I'm interested in the strategy hit rate, which is doing just fine. The net exposure to Australian shares as an asset class represents around 10% of the risk (variance) in my portfolio. I figure that the market will go up and, when pressed, will offer up an expectation of maybe 5%-9% per annum as a multi-decade total (pre franking) return. These figures are based off concepts along the lines which Craft has mentioned elsewhere and are used elsewhere in the industry for long range 'prediction'.

 

[Triathlete]

Most of the positioning is motivated by a systematic approach. It is an implementation of simple smart beta concepts and also the mispricing of franking credits. The portfolio is risk managed based on fundamentals like industry membership and also statistical properties. Other measures are observed. There is a fair bit going on. In terms of technicals, there is no crossing of MA lines, VWA, EWs etc. motivating any position. However, I do care about the historical pattern of returns in other ways and also for risk management. Even with the systematic approach as a base, nothing hits the market unless I am satisfied that the idea makes sense given what it is trying to achieve. In some cases, like MVF-AU, I will deep dive and any insights here are blended into the portfolio in a way which treats these insights as if they were another systematic source of return. Rebalancing occurs every month of two, whenever I get around to it. It's not that sensitive to this. Around 50 lines will trade each time, not all of which are complete closures or fresh opens.

What I do is not completely straight-forward. Given your questions are about the AEQ component, I suppose I could say that my concern is performance vs ASX 200 in this part and that it beats cash in general. Runs with a tracking error of 3% per annum. Aim to get about 2-3% per annum outperformance. Holding period is about a year. All going fine. Don't really know the stock level hit rate. Not something I watch. I'm interested in the strategy hit rate, which is doing just fine. The net exposure to Australian shares as an asset class represents around 10% of the risk (variance) in my portfolio. I figure that the market will go up and, when pressed, will offer up an expectation of maybe 5%-9% per annum as a multi-decade total (pre franking) return. These figures are based off concepts along the lines which Craft has mentioned elsewhere and are used elsewhere in the industry for long range 'prediction'.

Thanks DS,

I am actually not sure what you mean by "mispricing of franking credits" are you able to explain this part??
when you talk about "2-3% outperformance" you mean above the return of the ASX200 over the same timeline.??

Thanks again

Cheers
Triathlete

 

[qldfrog]

As always , very interesting, one area I am most concerned about is currency risk
Thanks for this exchange triatlete/DS,
With the AUD between 1.06 and 0.69 USD in the last few years, I believe the return I could expect from the share market are less significant and may not be worth the risk as opposed to currency swings;
I keep some exposure to teh market but probably the lowest i have ever had in the last 5/8 years
So my issue is : I have already lost more than 30% of my RE and firm assets in Australia vs the USD, could a similar think happen again?
74c to 55c/60c for teh AUD does not seem far reached, and in that case my cash position in AUD (aka my bank account, my RE are not safe)
So I try to diversify, have some gold and USD as an edge, I wonder also about getting some yen as some see it limited in the current race to the bottom of currencies
Lastly inflation: this is the elephant in the room, the ONLY way most of the western world government can avoid debt default; who am i to think I can oppose the obvious reserve banks target?
Cash, gold are so the obvious answer: I do not really care if I trade risk against safety and lower yield;
Return of capital before capital returns.
It does not sounds right, comes at a wrong time in my investment life but the economic environment does not seem right either: waiting for the helicopter money phase to come next.
Crazy? Too pessimistic (a natural trait for me)?

 

[DeepState]

Thanks DS,

I am actually not sure what you mean by "mispricing of franking credits" are you able to explain this part??
when you talk about "2-3% outperformance" you mean above the return of the ASX200 over the same timeline.??

Thanks again

Cheers
Triathlete

Franking credits are tax benefits payable to (most, but not all) Australian domiciled investors. Overseas investors don't enjoy the full benefit of these. Further, some market participants like market makers don't get to benefit from them either. As a result, there is a difference in the value of them which accrues to different participants in the market. Perhaps mispricing is the wrong term. Perhaps it would have been better for me to say that some market participants do not price franking and this offers an opportunity for those who do. A good chunk of the Australian equity market is also managed by fund managers who are generally measured on the basis of pre-tax returns. All things equal, Australian tax payers who benefit from franking should tilt towards stocks which pay franked dividends.

Outperformance does refer to a result relative to the ASX 200 Accumulation Index over any common timeline.

 

[skc]

I would be interested to know how you go about keeping on top of your 80 Direct Australian share holdings. Seems like a lot of work.

Not when you have a team of 8 FTE working in your family office...

I am actually not sure what you mean by "mispricing of franking credits" are you able to explain this part??

A good chunk of the Australian equity market is also managed by fund managers who are generally measured on the basis of pre-tax returns. All things equal, Australian tax payers who benefit from franking should tilt towards stocks which pay franked dividends.

I remember reading some academic research paper has shown that, on ex-div date, most companies share price fall by the amount of the dividend paid (all else being equal), rather than by the amount of grossed up dividend (which is dividend + franking credits). This has been the case after the introduction of the 45-day rule. You can certainly observe these in ex-div of popular fully franked income stock like TLS and banks.

Every now and then you get trading opportunities around these. Like takeovers and off market buybacks with large "franked special dividend" components and arb some mispriced franking credits (or if you could get international borrow on shorts... you can short the stock if it priced in franking).

 

[Triathlete]

Not when you have a team of 8 FTE working in your family office...

I remember reading some academic research paper has shown that, on ex-div date, most companies share price fall by the amount of the dividend paid (all else being equal), rather than by the amount of grossed up dividend (which is dividend + franking credits). This has been the case after the introduction of the 45-day rule. You can certainly observe these in ex-div of popular fully franked income stock like TLS and banks.

Every now and then you get trading opportunities around these. Like takeovers and off market buybacks with large "franked special dividend" components and arb some mispriced franking credits (or if you could get international borrow on shorts... you can short the stock if it priced in franking).

Thanks D/S and SKC

 

[DeepState]

In Brexit, apparently the UK would be clearly the biggest loser as its total trade with Europe would be affected. In Europe, each country's total trade with the UK is much smaller as a proportion of their individual economies. So...why, might you think, are we seeing this (FTSE revisiting recent pre-Brexit highs, Euro STOXX 50 not close to regaining these)?

 

[kid hustlr]

In Brexit, apparently the UK would be clearly the biggest loser as its total trade with Europe would be affected. In Europe, each country's total trade with the UK is much smaller as a proportion of their individual economies. So...why, might you think, are we seeing this (FTSE revisiting recent pre-Brexit highs, Euro STOXX 50 not close to regaining these)?

View attachment 67278

DS,

Have you seen the FTSE 100 vs the FSTE 250 over last week? Very different story I believe - I saw a chart of it midweek - I'll try to dig it up.

The theory was the FTSE 100 is extremely export heavy - benefiting from the lower GDP compared to the 250 which is more heavily linked to the domestic economy

 

[DeepState]

DS,

Have you seen the FTSE 100 vs the FSTE 250 over last week? Very different story I believe - I saw a chart of it midweek - I'll try to dig it up.

The theory was the FTSE 100 is extremely export heavy - benefiting from the lower GDP compared to the 250 which is more heavily linked to the domestic economy

The FTSE 250 has not recovered relative to pre-Brexit levels as well as the FTSE 100. However, a materially weakened GBP vs Euro would go some way to explaining the difference vs Euro STOXX 50....but not all.

 

[DeepState]

Minority or slim majority government. Fractured senate with 'ferals' still holding balance of power.

I would have thought:

Less likelihood of microeconomic reform. More uncertainty which will impede investment. Less foreign investment into productive assets. All sorts of BS compromises and targeted interests. Harder to react to things from the government/fiscal side.

One consequence:

Yet more weight given/shoved-on-to the RBA to do what needs to be done.

 

[skc]

Swiss bond yields now negative out to 50 years

https://next.ft.com/content/2ae4237a-2d3e-33dd-b9e0-120c4a93a29c

Swiss government bond yields all the way out to 50-year maturities have now all turned negative, as the global bond rally powers ahead amid deep economic uncertainty.

It's crazy to think that anyone can predict anything in finance out 50 years... yet somehow someone thought it's a good idea to pay the Swiss government almost 12 bps to lock up the money for 50 years.

50 freaking years

 

[DeepState]

Japan 20yr bonds also went negative. For a country whose debt load is basically nearly impossible to pay without unbearable austerity.

BoE Financial Stability Report is kind of sobering. Over-priced property assets. Current account deficit. Heavy private sector leverage. Wow...sound familiar? Responding as per the Chinese do with the Required Reserve Ratio manipulations. Cutting the counter-cyclical buffer and freeing up credit supply...except I thought credit was in fairly ready supply in the UK? Carney is more concerned for lack of demand.

The EU is really facing a credibility moment. Italian bank sovereign re-capitalisation. Fines on fiscal excesses for Portugal and Spain for breach of Stability and Growth Pact agreements.

The CHF bond market and the rest are pricing in emergency measures for decades. That, or the money sitting there losing real value prefers that to buying seriously overpriced assets whose forward looking returns are worse in their view.

When intermediated credit creation is being limited by regulators, lack of capital, broken balance sheets... on and on..

Gold is running.... head for the hills.