Wall Street’s Merry Pranks: Things that Matter #4

Lisa Simpson: Get out! Get out!
Bart Simpson: OK! But on my way, I’m going to be doing this. And if you get hit, it’s your own fault!
Lisa: OK, then I’m gonna start kicking air like this. And if any part of you should fill that air, it’s your own fault.
Marge Simpson: Hmm. I better go check that out. Now Homer…don’t. You. Eat. This. Pie!
Homer Simpson: Okaaaay. Alright pie, I’m just going to do this. And if you get eaten, it’s your own fault!
 The Simpsons, Season 6, Episode 8 “Lisa on Ice”

So much of the nudging from our smiley-faced authoritarian overlords on Wall Street sounds like it is coming from a mid-windmill Bart Simpson. I’m going to give you low-cost tools. I’m going to create ways to encourage you to trade them (frequently) at close to no cost (that you can see, anyway). And if you happen to trade so much that you create short-term gains everywhere, if you end up with an underdiversified portfolio that blows up, if you end up selling at the bottom and holding cash through half of the recovery…well… it’s your own fault.

Verbal: Who is Keyzer Söze?

He is supposed to be Turkish. Some say his father was German. Nobody believed he was real. Nobody ever saw him or knew anybody that ever worked directly for him, but to hear Kobayashi tell it, anybody could have worked for Soze. You never knew. That was his power. The greatest trick the Devil ever pulled was convincing the world he didn’t exist. One story the guys told me — the story I believe — was from his days in Turkey. There was a petty gang of Hungarians that wanted their own mob. They realized that to be in power you didn’t need guns or money or even numbers. You just needed the will to do what the other guy wouldn’t. After a while they come to power.

 The Usual Suspects (1995)

I originally intended to include nothing but Spacey quotes that feel much creepier and weirder than they did six months ago. I decided against it but had to keep the classic Söze line.

Why? Because the greatest trick any nudger, any libertarian paternalist ever pulls is always to convince the world they don’t exist. Their new business model, their new sales pitch, is all about the customer. They are just conveying it to you, and it’s really your decision whether you’re going to take advantage of it. But don’t mistake value for virtue — the magic of free markets is that they empower value-seeking behaviors to generate societally virtuous outcomes. The low-cost investing revolution and its sister — the movement to empower individual investors — has been a generational boon for investors. They created immense value. But never forget that this is a business and that these products are created by profit maximizers, not virtue maximizers. When we see branding and advertising that convey psychic or moral value from do-it-yourself and low-cost investing, we must know that we’re being nudged toward other less virtuous, riskier behaviors. 

Well, when all the people arrived in church, Eulenspiegel mounted the pulpit, said something from the Old Testament, tossed in the New as well, with Noah’s Ark and the Golden Bucket, in which the bread of Heaven Lay — and said, moreover, that all this stuff was the greatest holiness. Then at the same time he began to speak of the head of Saint Brendan, who had been a holy man. He had Brendan’s head right there — and it had been commanded of him that he use it to collect for the building of a new church, and to do so with purest goodness, never (on pain of death) accepting any offerings from any woman who might be an adulteress.

“And whoever here may be such women, let them stand back. For if they offer me something — those who are guilty of adultery — I won’t take it, and they will be revealed in shame unto me! So — know yourselves!”

Till Eulenspiegel: His Adventures, No. 31, Paul Oppenheimer (Editor/Translator)

The Söze-style penchant for creating havoc and disappearing into the background — and avoiding responsibility — is hardly new. It’s straight out of the playbook for the Trickster that exists within every major mythology. Till Eulenspiegel, a late middle ages version, is well known to Germans but almost completely unknown in America, which is a shame. This story is the best example I know of a trickster’s need to adapt his schemes to be more palatable when the world gets wise to him. Sound like any industries you know?


Some people always knew they wanted to be investors. They read Barron’s as a teenager and had their parents create an account for them to buy and sell stocks when they were 13.

Not me.

I wanted to be a composer. I would have settled for being an operatic tenor. If I couldn’t do that, I’d be willing to try my hand at being a musician in an orchestra. Short of that, I’d settle for being a drummer in a rock band. I supposed, if I couldn’t do any of those things, finance might be interesting enough. When I started the process of looking at universities, I considered pursuing each of these five things. I ultimately concluded that, if I were good enough at any of the first four, it wouldn’t matter if I had a degree saying that I was. So I studied finance. It’s a good thing, too, because it turns out I wasn’t nearly good enough at any of the others. I auditioned with some regional orchestras and opera companies, and got enough alternate work to pay for food and rent in college. It never would have gone any further than that.

Now, orchestral auditions are especially funny. These days, you’re called into the room and you sit in front of a screen. You are asked to play excerpts from the standard repertoire. I was a hornist. The horn is among the most versatile instruments, and so the point of the audition is to demonstrate your ability to perform all the things the horn is called upon to do. You need to display technical prowess, and so they ask you to play the famous horn call from Richard Wagner’s “Siegfried”. You need to display facility throughout the range of the instrument, so you are called to play the opening from “Ein Heldenleben”, by Richard Strauss. You must have a capacity for lyricism, for which you are asked to play the solo theme from the Poco Allegretto movement of Brahms’ Third Symphony, which has been shamelessly stolen by everyone from Sinatra to a weird and creepy Santana-Dave Matthews duo. Then they ask you to show you can do all of those things at once by playing the corno obbligato solo from Mahler’s Symphony No. 5.

But there’s one piece that shows up every time, even though it doesn’t get played by orchestras too terribly often: “Till Eulenspiegel’s Merry Pranks”. It’s another Strauss tone poem, and it is the Tower of Babel to every richly scored Merrie Melodies and Looney Tunes cartoon. Seriously, listen to the whole piece with your eyes closed, and your mind will fill in just where Bugs Bunny tricks Elmer Fudd into shooting his shotgun into a rabbit hole that sends it back through a funnel into Fudd’s face. The piece itself is a musical imagining of Germany’s version of the classic trickster character. Of course, it’s Germany, so the pranks are pretty dark, and most are scatological. As with many such stories, however, they also effectively highlight some of the absurdities of language and human behavior.

My favorite Till Eulenspiegel tale is the 31st of those that may have been assembled by Hermann Bote in the late 15th century. Paul Oppenheimer at CCNY did a lovely and sadly underbought translation, if you’re looking for an off-the-beaten-path and entirely inappropriate bedtime storybook. In this story, Eulenspiegel has become a bit too well-known to play his usual characters. A sort of Sacha Baron Cohen of the German late middle ages, if you will. He needs to find a new way to make money, and so he decides to pass himself off as a dealer in religious relics. He takes on a priest’s cassock and goes from town to town in Pomerania with a certain scam in mind. After procuring a skull from a graveyard, he inlays it with silver and asks the local priests — who are, naturally, universally corrupt and drunk — to allow him to raise money to build a new church in honor of the saint whose skull he carried. Which is, of course, just the remains of some dead blacksmith, but no matter. There is, however, a catch: our heroic church-building protector of holy relics is sworn never to accept donations from any woman who has ever committed adultery, and he will know if they are lying.

So who comes up to kiss the skull and drop some money in the pan?

Every woman in the church, of course. As soon as the first pious busybody makes her way up to demonstrate her faithfulness and purity (and to wait for the fireworks from her more libidinous sisters), all the other faithful wives don’t really have a choice. If she is going to go up there, then it’s not like they can avoid giving to the cause and proclaiming their virtue. Now, the guilty ones, their decision is a bit more complicated. Their bet is either that Eulenspiegel is a fraud or that he’s not. The alternative, not going up, results in the same outcome for them: being outed as an adulteress. So, for them, too, the best strategy is to kiss the skull and drop a coin or two in the basket. They were doomed to this roll of the dice as soon as the first woman walked to the front.

With every adulteress who comes to this conclusion, it’s easier for all the rest, because it’s more likely they’ve seen someone they know or suspect to be guilty come away blameless. At a certain point, despite Eulenspiegel’s bold words celebrating the holiness of their parish, most people have gotten wise. But who cares? We like the eggs. It’s a useful exercise for everyone. Eulenspiegel and the priest get paid. The pious confirm their piety. The guilty get a bit of public absolution, and even more license to continue their sin.

OK, great, so what does this have to do with finance, markets and politics? Well, “Till Eulenspiegel’s” is a story of those who would deceive us by exploiting our need to appear virtuous and good. It’s a story of the good among us proclaiming virtue and forcing the hands of others to proclaim it as well (whether they are virtuous or not). And when the non-virtuous join in the proclamations, it is a story of how they lean on their newly-found virtue to get themselves into some real trouble. Of course, by that time, Till Eulenspiegel has already gone full Keyzer Söze. He never even existed.

What virtue are we called upon to signal in finance, then? Well, is there any investing behavior more widely pursued, more universally lauded than low-cost, passive investing? Is there any trait more prized than empowerment of the individual investor to use those tools to take his investments into his own hands? When the industry comes to us, silver skull in hand and asking us to pledge ourselves to these virtues, most of us do so willingly. After all, we recognize that stock-picking is usually a waste of time. We recognize that spending a bunch of time fussing about which fund manager to pick is usually a waste of time.  And we don’t like to pay fees that don’t buy us anything.

This pound-the-table religion about active vs. passive management is all well and good for those of us in the business, who mostly live and breathe the Things that Matter. But for a universe of individual investors (and rather distressingly, probably some institutional investors, too), the message of empowerment is anything but. It’s a nudge into terrible portfolios, terrible costs and terrible outcomes. But hey, at least they got religion and implemented those terrible, far-too-actively-traded portfolios with ETFs!

I recognize that this is an odd way to start a note that’s going to be about the importance of costs in investing. And that really is what this note is about. It’s an especially odd way to start a note that’s going to characterize those costs as one of the big Things that Matter in investing. But while we walk through just how indispensable low-cost investment tools must be to any modern portfolio, what I really want to emphasize is that the order of this Code was not an accident. By and large, the decisions you make about risk, diversification and behavior are all going to impact your portfolio more than the expenses you are paying on funds or to your financial advisor.

Perhaps more controversially, I also want to observe that even among costs, those direct expenses will often fall short of other costs that get short shrift in most solutions offered: especially taxes, transaction and market impact costs, and the indirect costs imposed by buy/sell behaviors.

More to the point, I fear the empowerment of low-cost investing tools is making adulteresses of many of us.  Given license by a perception that buying a bunch of index funds makes us passive (it doesn’t), we actively trade those positions in ways that impose far more costs than we ever would have borne directly. We build portfolios that are excessively risky (or too defensive), underdiversified or dependent on single factors that produce long-term risk and return impacts that dwarf the costs of advice on portfolio construction. We trade portfolios for no cost without recognizing the terrible execution we are getting. We fire the only people holding us accountable for our behavior as investors — our financial advisors — to chart out our own course.

And the Pranksters and Priests of Wall Street love every minute of it.

The Most Important Development in Finance Since 1952

So now that I’m done negging on low-cost investing, let me give you a slightly more positive take: the availability of low-cost indexed vehicles to access the world’s financial markets is the single most important development in finance since at least the development of the 401(k) in 1978, and probably since Markowitz in 1952. It’s difficult to really measure the impact that indexing has had, because it has taken a variety of forms. Most people think of the direct impact of funds flowing from expensive actively managed mutual funds to indexed mutual funds and ETFs with a lower cost. This alone has had a multi-hundred-billion-dollar impact, retaining wealth in the hands of individuals that would otherwise have gone to fill the coffers of fund management companies. There has also been a direct shift from ownership of individual securities to index funds, which has had the effect of reducing commissions paid to brokers by an amount that is probably somewhat less. I haven’t seen a detailed study on the matter, but my back-of-the-envelope math says investors have accumulated something on the lower end of hundreds of billions here as well.

Indirect benefits have been significant, too. Because of prevalence of low-cost index fund options, active funds and other strategies have been under pressure to lower their costs in response. This kind of thing is hard to quantify, but as the guy running a fund management business, trust me… it’s a lot. And while all this was going on in retail land, we’ve observed financial futures contracts becoming more common, more liquid and among the most cost-effective means of accessing global financial markets for institutions. We have also seen hedge fund fees drop steadily, incentive fees shift toward a recognition of underlying market betas, and private equity managers begin to move away from fees on uncalled commitments. In a 2016 article, Bloomberg estimated the cumulative impact for asset owners at a cool trillion, give or take. I think this number is probably a bit light once the indirect impact is considered fully.

I argued in “You Still Have Made a Choice” that investors should think constantly about opportunity costs and the implicit bets they make in their portfolios. There, my focus was on the implicit bets we make on one asset class or investment to outperform another when we under diversify. One could just as easily apply that kind of thinking to the explicit expenses we pay. And they set a very high bar. If you think that you have a good chance of selecting a manager in a major asset class that is likely to consistently outperform the 70-80bps per year you typically save these days by selecting a comparable passive option, you are suffering from hubris, delusion or both.

The “Other” Direct Costs of Investing

OK, so the amount of ink spilled on saving the 70-80bps previously paid to financial advisors and fund managers is justifiably voluminous. But here’s where Eulenspiegel takes us for a ride — and where those of us jumping up to kiss the skull act as their accomplices: In celebrating this victory, we seem to assume that everyone else is using their newfound freedom from a financial advisor and an infinite array of index funds the same way that we are. We assume that they are long-term, diversified, generally buy-and-hold investors in command of their behaviors that are reveling in the synergy of that approach with an arsenal of low-cost solutions.

It is a pleasant fiction, isn’t it?

In a prior piece about the Things that Don’t Matter — “And They Did Live by Watchfires” — I referenced some of the data showing just how fictional that is, at least as it pertains to ETFs. Most of the data on average holding periods you can find pretty easily, something I encourage everyone to do. The data and reports you’ll find split the world into two pieces. On the one hand, you’ll find a lot of studies showing that average holding periods for ETFs are somewhat less than for other vehicles — usually around 1 ½ to 2 years — but still on the longish side. On the other hand, mean holding periods of the instruments themselves end up being shorter. Much shorter. In some cases, these periods can be measured in weeks. So what gives?

What gives is that you’ve got a very bipolar universe of users. Most of the world — especially people with financial advisors — see low-cost index strategies, whether they come in mutual funds, ETFs or futures contracts, as tools to develop an efficient portfolio. All hail us, the faithful wives. But you’ve also got a smaller universe of (mostly individual) investors who have rallied around the message of low-cost investing to execute strategies that are anything but. Witness the march of the adulteress army to the altar. How do I know these people exist, other than the fact that the data show that they exist?

Because I meet them every day. Because financial advisors tell me about them and ask me what to do about them every day. The amount of bitcoin day-trading, TVIX-flipping, SPY-to-QQQ-to-IWD swapping that goes on in some individual investor accounts is shocking. And to a one, these investors are painfully cost-conscious. They wouldn’t dream of paying a management fee to a fund manager. And paying a financial advisor? Forget about it!

And yet.

The Petajisto paper referenced in “Watchfires” covers trading costs reasonably well, although increases in size and volume of the market have almost certainly narrowed some of the spreads since it was originally published. Still, trading costs of any actively traded strategy have the potential to be as large as the average difference between a passive and active fund. All investors should be thinking about trading costs as a Thing that Matters every bit as much as direct advisory costs, and based on my conversations with advisors and individual investors, I don’t think most investors give it much of a thought at all.

Separately, and potentially far more importantly, the kind of activity implied by the increased turnover of this special class of investors in low-cost vehicles can have a massive impact on taxes. In the chart below, I show the equivalent advisory fee you would pay in order to equal the impact of different levels of annual short-term taxable turnover.

Source: Salient 2017. For illustrative purposes only.

Let’s unpack that. Assume, for example, that you had a 20-year horizon. Now assume that every year you turned over 40% of your portfolio, and that you did so with positions that produced short-term gains. This is fairly typical of the activity I see even from goody two-shoes virtue-signaling investors and advisors like me, whose average holding periods are in the 18-to-24-month range. Even in this case, the impact from taxes is the same as paying a 75bp advisory fee to a fund manager or financial advisor. Now imagine (or just look above to see) what a more actively traded approach is going to look like. It’s not pretty.

Now, I’ve made a lot of fuss about how some misguided investors are misusing index funds and ETFs, but this isn’t really about that. Frankly, this is a point that needs to be heard by investors in any commingled vehicle, mutual funds and hedge funds perhaps more than any, so I want to say this as clearly as I can: if you are a taxable investor, taxes matter more than fees, and you’re not paying enough attention to them.

No, Virginia, You’re Not a Passive Investor

The “vehicle-centric” view of investing guides investors toward do-it-yourself solutions where the only important consideration is whether you’re paying an explicit fee. The resultant behaviors for a portion of those investors lead to disproportionate tax impacts, and they lead to transaction costs. There’s a reason why I’ve written that Investor Behavior Matters. But those behaviors matter most when they impact the two biggest decisions that investors must make: how much risk to take and where to take it (diversification).  So, unsurprisingly, I do want to take another opportunity to remind everyone that they aren’t passive investors just because they bought a bunch of index funds. In “I am Spartacus”, I put this in context of a global portfolio of financial assets. Here, I want to take a different tack.

Let’s assume that the world of index funds (here, I use ETFs, but could just as easily be mutual funds) consisted of the 100 largest such vehicles as they exist today. Now consider an exercise in which we decided we wanted to buy 10 of those funds at random, assigning them 10 different portfolio weights (also at random). If we did this random selection, say, 100,000 times, how often would we have gotten different risk and return outcomes[1]? How much would they really differ from one another? Basically, what I’m trying to answer is, “If I had absolutely no insight into asset allocation, but was being told I needed to keep costs down and do the investing myself, what is the range and likelihood of different portfolios I could end up with using those instruments.” The table below shows the answer.

Source: Salient 2017. For illustrative purposes only.

First, how do we interpret this? In short, the difference between good and bad asset allocation decisions is big. It’s bigger than taxes. It’s bigger than transaction costs. It’s bigger than advisory fees. And if you are assuming that you don’t really have a lot of ex ante insights, that’s kind of a big deal.

A nice portion of the portfolios cluster around a 6-8% return with 12-14% volatility, but they’re only about 17% of the total. More than 43% of the portfolios have returns that differ materially (by 2-4%). And if you’re comparing the best 20% to the worst 20% of portfolios we could have selected, you’re talking as much as a 6% annualized difference in returns, with correspondingly large differences in the amount of risk you were taking to achieve it. And this is just including the Top 100 ETFs, which are largely confined to large, liquid, broad market instruments, and not the more esoteric options that begin to fill up the portfolios of many practitioners.

To many readers this is certainly intuitive, and so I don’t pretend I’m making a novel point here by saying that asset allocation matters. Other readers might criticize this by saying, “Surely we should expect more from folks than just a random allocation to funds.” This is the point in the conversation where I would stare at you intently, but quietly, until you amended your statement to something less stupid so that we could continue our erstwhile cordial discussion.

More novel, however, is the observation that — in rough numbers — a better than random approach to asset allocation can matter to the tune of 2-6x the impact of a typical active fund’s fees.

In Defense of the Financial Advisor

So yes, Costs Matter. And if you asked me how much each of these direct and indirect costs matter, my very generalized, not-at-all-personalized for you list would look something like this:

  1. Indirect Behavioral Costs on Asset Allocation Decisions
  2. Taxes
  3. Advisory Fees (Tie) / Transaction Costs (Tie)

One of the responses Ben and I invariably get from readers is, “Include more actionable ideas!”, so I’m ready for the chorus of, “OK, I get it. What do I do?” Here’s what you do:

Hire and pay a financial advisor.

Before anyone jumps in, I’m not telling you to pay a bunch of high fees for actively managed strategies in markets where they don’t have a prayer of producing sustained outperformance after those fees. God knows homo marketus can find just as many perfectly good ways to create taxable gains and transaction costs in actively managed solutions as well.

What I AM telling you is that you should find someone who you trust. Find someone who is looking out for you on taxes. Find someone who is looking out for you on transaction costs. Find someone who tells you the truth about how much you’re paying them. Find someone who is going to save you from your fear when you want to sell low, and who will protect you from your greed when you want to buy high. Find someone who will keep you diversified when you want to take stupid risks in markets and securities where you don’t have an edge (which is all of them — sorry). Find someone who isn’t trying to get you to trade in and out of new ideas all the time. Find someone who doesn’t sell to you with Eulenspiegel-style virtue signals. Find someone who doesn’t disappear like Keyzer Söze when things go wrong.

Find someone who will treat you like a partner, and pay them.

But not too much.

[1] Here, we present this as a historical analysis. No resampling, etc.

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Notes From the Field

To make a prairie it takes a clover and one bee,
One clover, and a bee,
And revery.
The revery alone will do,
If bees are few.
― Emily Dickinson (1830 – 1886)


I’ve said it before, and I’ll say it again.
Emily Dickinson is a total badass.

When a livestock farmer is willing to “practice complexity”— to choreograph the symbiosis of several different animals, each of which has been allowed to behave and eat as it evolved to — he will find he has little need for machinery, fertilizer, and, most strikingly, chemicals. He finds he has no sanitation problem or any of the diseases that result from raising a single animal in a crowded monoculture and then feeding it things it wasn’t designed to eat.
Michael Pollan, The Omnivore’s Dilemma: A Natural History of Four Meals (2006)

In modern farming and in modern investing, we have become prisoners of the monoculture. It’s efficient. It’s necessary for a mass society of ever-increasing Desire. And yet …

Oh, and one more thing. In the investment monoculture, you’re not the farmer.

Up on the Ft. Peck Reservation
(Assiniboine and Sioux)
just as I passed two white crosses
in the ditch I hit a fledgling meadowlark,
the slightest thunk against the car’s grille.
A mean minded God
in a mean minded machine, offering
another ghost to the void to join the two
white crosses stabbing upward in the insufferable
air. Wherever we go we do harm, forgiving
ourselves as wheels do cement for wearing
each other out. We set this house
on fire forgetting that we live within.
 Jim Harrison, “To a Meadowlark” (2008)

One thing that has gone wrong in America is the general acceptance of bad ham.
Jim Harrison (1937 – 2016)

After gaining widespread fame as an explorer and “Indian fighter” during the Revolutionary War (yes, that used to be a profession, and a respected one), Daniel Boone earned his living in the Kentucky wilderness by producing what was known as bear bacon. It wasn’t “bacon” as we know it today, which typically comes from the sides and bellies of pork. Instead, Boone would take the whole bear and portion it into large hunks of meat that were brined and smoked. Living out of a lean-to shelter, he and his family hunted the bears with the help of tracking hounds. They soaked the meat in handmade barrels filled with a brine of water, salt, and sugar. They got the salt from mineral licks, and they got sugar by tapping the sweet sap from maple trees. Once the meat was brined, it was smoked and loaded onto keelboats headed up the Ohio River. Riding along with the meat were barrels of lard, rendered down from bear fat, as well as stretched and dried bear hides. All of it was sold in the eastern settlements. In one particularly productive season, Boone brought to market the meat and by-products of 155 black bears.
Steven Rinella, “First Catch Your Bear: Recipe for Smoked Black Bear Ham,” Cured v.1, Fall 2016

I had a coonskin cap when I was a wee lad, and I can still sing the Daniel Boone theme song. Not sure I can imagine Patricia Blair boiling down bear fat and living in a lean-to, any more than I can imagine Fess Parker being an “Indian fighter”. I mean … the bad Indians, sure, but Daniel Boone was a great friend to the good Indians like Mingo. Right?

Of all the occupations by which gain is secured, none is better than agriculture, … none more becoming to a free man.
Cicero (106 – 43 BC)

Men are not so much the keepers of herds as herds are the keepers of men.
Henry David Thoreau, Walden (1854)

The land is ours. We are the land’s.

Robert Frost wrote a similar line to lead off a patriotic anthem (“The Gift Outright”), most famously delivered at JFK’s inauguration when he was 87 years old. The poem rings poorly to the modern ear. Too jingoistic. Too rah-rah. But there’s a deeper meaning, I think, whether Frost intended it or not. The land is ours. There is a freedom that comes from working one’s own land, a groundedness — in the truest sense of the word — that was the foundation of Roman civilization and the republican virtues that inspired Jefferson, Madison, Hamilton, and the rest of the Founders gang.

But the land owns us, too. That encompasses nationalism and patriotic duty, for sure, which is how I think Frost meant it. It also encompasses civic and social duty, which is how I mean it. This is the price of civilization, that we allow ourselves to be the land’s. It’s a price worth paying.

Regular Epsilon Theory readers may know that I’m originally from Alabama but now live out in the wilds of Fairfield County, Connecticut. Politically this is a failed state, but it’s still a beautiful one, and we’ve had nothing but happiness raising our four daughters here on a “farm” of 44 acres. I put that word in quotations because although we have horses and sheep and goats and chickens and bees, my grandfather — who owned a pre-electrification, pre-refrigeration, pre-pasteurization dairy farm in Alabama during the 1920s and 1930s — would surely have a good belly laugh at the notion of calling this a “farm”. But it’s a farm to us, and it’s been the bedrock for how we’ve educated our girls, who along with their mother do every bit of the work required to keep these animals alive (except for the bees, which are my thing, and anything that requires using the tractor). There are lessons from training a mustang to take a saddle, from shearing a sheep, from watching how goats defend the weak and how chickens torture the weak … lessons that have made my daughters strong and wise way beyond their years … lessons that you can’t get anywhere else but a farm.

It’s been a learning experience for me, too, of course. The dilettante farmer has been a stock comedic character since Cicero’s day, and Eddie Albert on Green Acres is a farming savant compared to me. One of the nice things about the land, though, is that it doesn’t hold a grudge. It forgives. Stick with it long enough and you can start figuring out the rhythms, or at least injure yourself less frequently. Plus, in case I wasn’t clear earlier, this is freakin’ Fairfield County, Connecticut. I’ve installed a really excellent wifi router in my barn so I can download instructional videos on, say, replacing the oil filter on my tractor. I expect Amazon Prime drone delivery service for said filter to start up any day now. And if all else fails it’s a 10-minute drive to a couple of really good bars where I can nurse my wounded pride with some artisanal Mezcal and whatever locally-sourced amuse-bouche the chef has whipped up that day. I mean, this isn’t exactly Grapes of Wrath material.

By the way, the joke in that last paragraph for farming cognoscenti is how easy it is to change an oil filter on a modern tractor. It’s a four-inch canister that pokes out from the engine. You literally unscrew it by hand (“remember, lefty-loosey!” says the instructional video, clearly designed for dilettante Team Elite tractor owners like me) and screw the new one on tight. Maybe put a little fresh oil in the new filter before attaching if you wanna show off a bit. But, yeah, that’s all it is.

Still, I have learned a few things over the years from the farm and its animals, and they’ve helped me to become a better investor. Those are the notes from the field that I want to share in this Epsilon Theory letter.

#1: Fingernail Clean

Fresh eggs are, in fact, one of the best things in life, and they (almost) make up for the necessity of dealing with the evil reptilian brain of the modern-day chicken. A fresh egg is notable for both its yolk (an orange-yellow that seems to glow, not the flat yellow-yellow you get in a store-bought egg) and its white (the fresher the albumen, the greater its coherence, so that you can, for example, poach a very fresh egg without putting vinegar in the water). A fresh egg is also notable for the fact that, depending on where it was laid and when it was collected, it may have dried chicken poop on the shell.

Now an eggshell is semi-permeable, and a fresh eggshell has a thin anti-bacterial protective layer called the “bloom”, so you don’t want to soak it in soapy water, or really any water at all. You can use an enzymatic egg wash to loosen the “dirt”, but really all you need to do is moisten the spot and scrape it with your fingernail until it’s clean. Not scrubbed. Not pristinely clean. Just fingernail clean. That’s really the optimal outcome.

Here’s another truth about fresh eggs: you don’t need to refrigerate them. They’ll keep for a month just sitting out on your kitchen counter. They don’t rot. They don’t start to smell. They don’t serve as a Petri dish for salmonella or some other dread bacterium. Seriously.

So you don’t have to refrigerate your fresh eggs. But if you scrub your eggs all nice and perfectly clean, removing the anti-bacterial bloom layer in the process, then you have to refrigerate them. Similarly, if you start refrigerating an egg, then you have to keep refrigerating it. You can’t go back and forth.

Of course, you can’t scrape eggs fingernail clean on an industrial scale, and there really are dread diseases running rampant in every industrial protein monoculture facility, whether it’s for eggs or chickens or cows or pigs or whatever, which is why antibiotics are constantly fed to these animals. You can’t be certain that industrially produced eggs will get to a buyer within a month, and you certainly can’t be certain they’ll be kept at room temperature over that span. So you wash the hell out of the industrially produced egg, and you introduce it to refrigeration as soon as you can for storage and transport. That’s why the spotless, refrigerated egg is all we know. It’s necessary for effective and profitable industrial production.

But because the spotless, refrigerated egg is all we know, we believe anything to the contrary must be a defective and potentially diseased egg. Not a better egg, which is the truth, but a worse egg. A bad egg. You see this all the time when you give people fresh eggs. They’re disturbed if the eggs aren’t housed in an egg carton and cool to the touch. They get freaked out if the eggs aren’t perfectly, and I mean perfectly, clean.

We have been well and truly trained to accept the Industrially Necessary Egg as the Good Egg.

It’s the same with all dairy products. It’s the same with all industrially produced proteins. It’s the same with all industrially produced anything.

So many ideas that we take as immutable truths of safety or goodness, whether those truths concern the food we eat or the stocks we buy, are not truths at all. They are conveniences, and not conveniences for us, but for the sellers of the food we eat or the stocks we buy.

Do you really think that an ETF (and let’s recall what those letters stand for — an Exchange Traded Fund) was designed for your benefit? I wrote the following in September, 2015 in an Epsilon Theory note called “Season of the Glitch”. It bears repeating.

The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug.

More recently, both Rusty Guinn and I have been hammering on this point in Epsilon Theory notes: ETFs are the epitome of active trading. They exist because we can’t help ourselves. We demand the ability to actively manage our portfolio on a minute-by-minute, second-by-second basis. We’re addicted to the “news” on CNBC and the rush we get from playing the hand and the false sense of security we derive from the immediate liquidity and the false satisfaction we derive from making the decision ourselves. We fancy ourself to be a macro investor — able to select this sector or that sector, this geography or that geography, this theme or that theme, this asset class or that asset class — and that’s why ETFs exist. We’ve been sold the idea that we’re excellent macro investors, just as smart and observant and on top of things as all those fat cats we read about. We’ve been sold the idea that it’s a Good Thing for us to “take control” of our portfolio and give the boot to all of those “so-called experts” with their “out of control fees”.

It’s a powerful idea because, like all powerful ideas, there’s more than a little truth to it. Fees are often too high. Experts and advisors are often just marketing shills. That’s all true. But what’s also true is that you are not an excellent macro investor. Sorry. And more to the point, there’s no need for you to be an excellent macro investor and still achieve your investment goals. But so long as we allow ourselves to be well and truly trained into believing that the Industrially Necessary Financial Innovation is the Good Financial Innovation, it’s harder to achieve those goals. Like a store-bought egg, ETFs are occasionally necessary, and always convenient. But they can’t hold a candle to a fingernail clean fresh egg.

#2: Structure Is a Cruel Master

I like animals that pay the rent. It’s why I put up with chickens and sheep, both of whom are just about the stupidest and most selfish animals on this green earth. And it’s why I’m particularly interested in bees, because honey is the best rent I collect. Honey is another food product where, like eggs, the necessities of industrial production have led to the general acceptance of bland honey as good honey. In truth, the best tasting and healthiest honey will have bits of raw pollen in it, maybe a bit of wax, maybe — brace yourself — other impurities. But that’s not my point in this note from the field. My point here is about the particular genius of bees, which is that they are hard-wired to create amazing structure out of complete chaos. Usually that genius results in a triumph of both social and physical engineering, but occasionally it goes awry. Ditto for humans.

I use a top-bar hive design for my bees, rather than the far more common Langstroth hive design. The top-bar hive essentially mimics a hollow log, providing nothing more than a flat ceiling and some holes in the “log” for the bees to fly in and out. It’s completely up to the bees how they build their combs within the “log”, and I’ve got a plastic window on one side of the structures so I can see their progress. Think of it like an ant farm for grownups. Alternatively, the Langstroth design forces the bees to build their combs in a deterministic manner, providing pre-waxed, precisely distanced slats within tight boxes that can easily be stacked and moved. The Langstroth hive is a wonderful design for transporting bees for commercial pollination services, and similarly effective for maximizing honey production and extraction. Neither of which I care about.

What I do care about, beyond collecting the occasional honey comb, is understanding, experiencing, and learning from the bees, and that’s what a top-bar hive allows me to do. The downside to a top-bar hive is that it doesn’t provide any “guardrails”, to use a management term du jour, for the bees. Plus, any honeycombs you collect are likely to have a few, or more than a few, larvae in the comb, making it more of a challenge to extract the honey without the yucky stuff. But both of these negatives are positives in my book. I’m not trying to get a ton of honey, and I want the responsibility of identifying and rectifying any structural wrongs that might develop in the hive. Or so I thought.

My first year with a top-bar hive, I thought it would be helpful if I gave my new colony a bit of a head start by placing some pre-waxed Langstroth hive sheets (basically a wax sheet held together with thin strands of wire) in the bottom of their “log”. Sure enough, the bees quickly harvested the wax and used it for their new combs, leaving the thin wires at the bottom of the hive. Mission accomplished!

One month later, though, and my hive was a mess. The bees didn’t physically harvest the thin metal wires like they had the pliable wax, but they had harvested the idea of the wires. You see, bees will use any structure as a template for their structure-building instincts. The reason a top-bar hive works is that it mimics a hollow log. Any structure within the log, any at all, even a few wires jumbled at the bottom, will be seized on as a structural framework. So instead of only getting the classic honeycomb built from the ceiling down in beautiful straight lines with exactly ¾ of an inch between combs, I also got a blob comb built from the floor of the hive up. To make matters worse, I had made the newbie mistake of not ensuring that my full hive, the “log” itself, was perfectly level when I set it up, and as a result the ceiling-built combs were listing downhill. Put it all together, and I got the disaster structure: cross-comb, where your hive becomes a maze of interlocked combs and lobes, impossible to interact with without destroying big chunks of the hive and killing large numbers of bees. If you’ve ever mistreated an engine to the point where it seized up, fusing into a solid block of metal, then you have a good notion of what I had done to this hive.

And here’s the kicker. I knew this was happening (remember the plastic window so I can see into the hive), and I still did nothing to stop it. Or rather, I suspected that something bad was happening, and rather than dig in and kill a few bees and wreck a small amount of comb in order to scrape out the wires and get the hive on the right track, I didn’t want to pay that price. There’s no way, I kept telling myself, that these bees would become so utterly focused on building around a few metal wires that obviously weren’t part of the master plan and obviously didn’t lead to a properly built hive. I was wrong.

So what are my lessons here?

Investors are like these bees, determined to find structure — i.e., meaning — in anything the beekeeper or nature gives them. They will find structure and meaning even if the beekeeper intended no such thing. They will find structure and meaning even if what they build is obviously flawed. They will keep building on this flawed foundation for as long as they are physically able to do so.

The architectural design for a beautiful end result — a productive hive or a productive portfolio or a productive market — is nowhere to be found in a bee’s brain or a human’s brain. What is in our brains is an algorithm — a process — where we take meaning from found structures and we build on them. And build and build and build. That’s what the bee and the human are biologically evolved to do, and that’s exactly why the bee and the human are two of the most successful species on the planet. Our algorithms work. For both bees and humans, our process is our genius. And it usually ends up as a grand success. Unless, of course, we’ve been given a flawed foundation. Unless, of course, we’re finding structure and meaning in a bunch of wires on the floor of the hive.

Central bankers are like me, the Hamlet-esque, dithering newbie beekeeper who left a destructive structure in the hive but can’t bring himself to accept that fact. Central bankers absolutely think of themselves as beekeepers. They absolutely believe that they, and only they, can keep the global economy from going off the rails. They absolutely believe that they provided the necessary materials to keep the hive alive in 2009 and 2012, albeit admittedly with a bit of detritus left behind in the form of massive balance sheet reserves. They absolutely do NOT believe that removing these reserves will be a big deal, so long as they keep saying the right words and go very very slowly. They are wrong.

To use another pastoral reference, what’s good for the goose is good for the gander. If Bernanke was right about the portfolio rebalance channel on the way up, he’s going to be right about the portfolio rebalance channel on the way down. What’s the portfolio rebalance channel? It’s the whole entire rationale for QE, the whole entire reason that central banks now own $14 TRILLION worth of stuff. By buying their fixed income stuff, central banks push down the yield on ALL fixed income stuff. They make ALL investors take on more risk than they otherwise would. The safe-as-houses U.S. Treasury buyer has to buy mortgages to get the same portfolio return as before. The cautious mortgage buyer has to buy corporate debt to get the same portfolio return as before. The corporate debt buyer has to buy equities to get the same portfolio return as before. It’s turtles all the way down. And it will be turtles all the way up as ALL investors are forced to take on less risk than they otherwise would.

This algorithm — what I’ve called in the past the Narrative of Central Bank Omnipotence, or the idea that Central Banks are responsible for all market outcomes — is now well and truly implanted in the human brain. Maybe it’s not in your brain. Good for you (although I don’t believe you). But would you deny that it’s implanted in enough human brains to make all the difference in market behaviors? I don’t know whether Bernanke was right about the portfolio rebalance channel. And I don’t care! What I care about is that enough people believe that the portfolio rebalance channel worked, just like enough people believe that Draghi’s Outright Monetary Transaction program worked, so that it DOES work. In either direction.

To make a prairie it takes a clover and a bee. Plus revery. Belief.

And belief alone will do.

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Season of the Glitch

When I look over my shoulder
What do you think I see?
Some other cat lookin’ over
His shoulder at me.

Donovan, “Season of the Witch” (1966)

epsilon-theory-season-of-the-glitch-september-3-2015-blair-witch

Josh Leonard: I see why you like this video camera so much.
Heather Donahue: You do?
Josh Leonard: It’s not quite reality. It’s like a totally filtered reality. It’s like you can pretend everything’s not quite the way it is.

“The Blair Witch Project” (1999)

Over the past two months, more than 90 Wall Street Journal articles have used the word “glitch”. A few choice selections below:

Bank of New York Mellon Corp.’s chief executive warned clients that his firm wouldn’t be able to solve all pricing problems caused by a computer glitch before markets open Monday.

“BNY Mellon Races to Fix Pricing Glitches Before Markets Open Monday”, August 30, 2015

A computer glitch is preventing hundreds of mutual and exchange-traded funds from providing investors with the values of their holdings, complicating trading in some of the most widely held investments.

“A New Computer Glitch is Rocking the Mutual Fund Industry”, August 26, 2015

Bank says data loss was due to software glitch.

“Deutsche Bank Didn’t Archive Chats Used by Some Employees Tied to Libor Probe”, July 30, 2015

NYSE explanation confirms software glitch as cause, following initial fears of a cyberattack.

“NYSE Says Wednesday Outage Caused by Software Update”, July 10, 2015

Some TD Ameritrade Holding Corp. customers experienced delays in placing orders Friday morning due to a software glitch, the brokerage said..

“TD Ameritrade Experienced Order Routing, Messaging Problems”, July 10, 2015

Thousands of investors with stop-loss orders on their ETFs saw those positions crushed in the first 30 minutes of trading last Monday, August 24th. Seeing a price blow right through your stop is perhaps the worst experience in all of investing because it seems like such a betrayal. “Hey, isn’t this what a smart investor is supposed to do? What do you mean there was no liquidity at my stop? What do you mean I got filled $5 below my stop? Wait… now the price is back above my stop! Is this for real?”  Welcome to the Big Leagues of Investing Pain.

What happened last Monday morning, when Apple was down 11% and the VIX couldn’t be priced and the CNBC anchors looked like they were going to vomit, was not a glitch. Yes, a flawed SunGard pricing platform was part of the proximate cause, but the structural problem here – and the reason this sort of dislocation WILL happen again, soon and more severely – is that a vast crowd of market participants – let’s call them Investors – are making a classic mistake. It’s what a statistics professor would call a “category error”, and it’s a heartbreaker.

Moreover, there’s a slightly less vast crowd of market participants – let’s call them Market Makers and The Sell Side – who are only too happy to perpetuate and encourage this category error. Not for nothing, but Virtu and Volant and other HFT “liquidity providers” had their most profitable day last Monday since … well, since the Flash Crash of 2010. So if you’re a Market Maker or you’re on The Sell Side or you’re one of their media apologists, you call last week’s price dislocations a “glitch” and misdirect everyone’s attention to total red herrings like supposed forced liquidations of risk parity strategies. Wash, rinse, repeat.

The category error made by most Investors today, from your retired father-in-law to the largest sovereign wealth fund, is to confuse an allocation for an investment. If you treat an allocation like an investment… if you think about buying and selling an ETF in the same way that you think about buying and selling stock in a real-life company with real-life cash flows… you’re making the same mistake that currency traders made earlier this year with the Swiss Franc (read “Ghost in the Machine” for more). You’re making a category error, and one day – maybe last Monday or maybe next Monday – that mistake will come back to haunt you.

The simple fact is that there’s precious little investing in markets today – understood as buying a fractional ownership position in the real-life cash flows of a real-life company – a casualty of policy-driven markets where real-life fundamentals mean next to nothing for market returns. Instead, it’s all portfolio positioning, all allocation, all the time. But most Investors still maintain the pleasant illusion that what they’re doing is some form of stock-picking, some form of their traditional understanding of what it means to be an Investor. It’s the story they tell themselves and each other to get through the day, and the people who hold the media cameras and microphones are only too happy to perpetuate this particular form of filtered reality.

Now there’s absolutely nothing wrong with allocating rather than investing. In fact, as my partners Lee Partridge and Rusty Guinn never tire of saying, smart allocation is going to be responsible for the vast majority of public market portfolio returns over time for almost all investors. But that’s not the mythology that exists around markets. You don’t read Barron’s profiles about Great Allocators. No, you read about Great Investors, heroically making their stock-picking way in a sea of troubles. It’s 99% stochastics and probability distributions – really, it is – but since when did that make a myth less influential? So we gladly pay outrageous fees to the Great Investors who walk among us, even if most of us will never enjoy the outsized returns that won their reputations. So we search and search for the next Great Investor, even if the number of Great Investors in the world is exactly what enough random rolls of the dice would produce with Ordinary Investors. So we all aspire to be Great Investors, even if almost all of what we do – like buying an ETF – is allocating rather than investing.

The key letter in an ETF is the F. It’s a Fund, with exactly the same meaning of the word as applied to a mutual fund. It’s an allocation to a basket of securities with some sort of common attribute or factor that you want represented in your overall portfolio, not a fractional piece of an asset that you want to directly own. Yes, unlike a mutual fund you CAN buy and sell an ETF just like a single name stock, but that doesn’t mean you SHOULD. Like so many things in our modern world, the exchange traded nature of the ETF is a benefit for the few (Market Makers and The Sell Side) that has been sold falsely as a benefit for the many (Investors). It’s not a benefit for Investors. On the contrary, it’s a detriment. Investors who would never in a million years consider trading in and out of a mutual fund do it all the time with an exchange traded fund, and as a result their thoughtful ETF allocation becomes just another chip in the stock market casino. This isn’t a feature. It’s a bug.

What we saw last Monday morning was a specific manifestation of the behavioral fallacy of a category error, one that cost a lot of Investors a lot of money. Investors routinely put stop-loss orders on their ETFs. Why? Because… you know, this is what Great Investors do. They let their winners run and they limit their losses. Everyone knows this. It’s part of our accepted mythology, the Common Knowledge of investing. But here’s the truth. If you’re an Investor with a capital I (as opposed to a Trader with a capital T), there’s no good reason to put a stop-loss on an ETF or any other allocation instrument. I know. Crazy. And I’m sure I’ll get 100 irate unsubscribe notices from true-believing Investors for this heresy. So be it.

Think of it this way… what is the meaning of an allocation? Answer: it’s a return stream with a certain set of qualities that for whatever reason – maybe diversification, maybe sheer greed, maybe something else – you believe that your portfolio should possess. Now ask yourself this: what does price have to do with this meaning of an allocation? Answer: very little, at least in and of itself. Are those return stream qualities that you prize in your portfolio significantly altered just because the per-share price of a representation of this return stream is now just below some arbitrary price line that you set? Of course not. More generally, those return stream qualities can only be understood… should only be understood… in the context of what else is in your portfolio. I’m not saying that the price of this desired return stream means nothing. I’m saying that it means nothing in and of itself. An allocation has contingent meaning, not absolute meaning, and it should be evaluated on its relative merits, including price. There’s nothing contingent about a stop-loss order. It’s entirely specific to that security… I want it at this price and I don’t want it at that price, and that’s not the right way to think about an allocation.

One of my very first Epsilon Theory notes, “The Tao of Portfolio Management,” was on this distinction between investing (what I called stock-picking in that note) and allocation (what I called top-down portfolio construction), and the ecological fallacy that drives category errors and a whole host of other market mistakes. It wasn’t a particularly popular note then, and this note probably won’t be, either. But I think it’s one of the most important things I’ve got to say.

Why do I think it’s important? Because this category error goes way beyond whether or not you put stop-loss orders on ETFs. It enshrines myopic price considerations as the end-all and be-all for portfolio allocation decisions, and it accelerates the casino-fication of modern capital markets, both of which I think are absolute tragedies. For Investors, anyway. It’s a wash for Traders… just gives them a bigger playground. And it’s the gift that keeps on giving for Market Makers and The Sell Side.

Why do I think it’s important? Because there are so many Investors making this category error and they are going to continue to be, at best, scared out of their minds and, at worst, totally run over by the Traders who are dominating these casino games. This isn’t the time or the place to dive into gamma trading or volatility skew hedges or liquidity replenishment points. But let me say this. If you don’t already understand what, say, a gamma hedge is, then you have ZERO chance of successfully trading your portfolio in reaction to the daily “news”. You’re going to be whipsawed mercilessly by these Hollow Markets, especially now that the Fed and the PBOC are playing a giant game of Chicken and are no longer working in unison to pump up global asset prices.

One of the best pieces of advice I ever got as an Investor was to take what the market gives you. Right now the market isn’t giving us much, at least not the sort of stock-picking opportunities that most Investors want. Or think they want. That’s okay. This, too, shall pass. Eventually. Maybe. But what’s not okay is to confuse what the market IS giving us, which is the opportunity to make long-term portfolio allocation decisions, for the sort of active trading opportunity that fits our market mythology. It’s easy to confuse the two, particularly when there are powerful interests that profit from the confusion and the mythology. Market Makers and The Sell Side want to speed us up, both in the pace of our decision making and in the securities we use to implement those decisions, and if anything goes awry … well, it must have been a glitch. In truth, it’s time to slow down, both in our process and in the nature of the securities we buy and sell. And you might want to turn off the TV while you’re at it.

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