Weekly Edition #74

In this edition:

Fascinating chart that shows rates of return depending on when you started investing and when you withdrew your investment. We always hear about long term returns. US stocks have averaged 9-10% before inflation and taxes since the 1920s. This might be a reasonable expectation for very long-term investments; however, over shorter time periods returns can be very different than 9%. The chart shows annualized returns after taxes and inflation for all starting and ending points between 1920 and 2010.

A couple of interesting points (note all returns are after inflation and after average fees and taxes):

  • – The best 20 years ended in 1968 in which the market returned 8.4% per year
  • – The worst 20 years ended in 1981 in which returns were -2.0% per year
  • – The median 20-year return was 4.1%
  • – Inflation really kills investment returns; the worst periods were around the 1970s in which returns were negative for several staring/end points
  • – If you would have invested in 1929 and withdrawn in 2010 (over 8 decades), you would have barely kept up with inflation

The takeaway here is that starting and ending points matter a great deal. As more time passes, returns tend to converge towards the median, but these time frames can be very long. This is why we always say that we need to diversify. If you invest, invest in a diversified mix of assets, not only in stocks. If you invest in stocks, invest globally, not only in US stocks. Stocks earn positive returns over the long-term because they compensate you for risk taken. Yes, stocks tend to go up over time, but this is by no means a guarantee. If stocks always had high returns over the long run, then what risk are they compensating you for? The risk is that there are periods of over 80 years where stocks barely keep up with inflation. There are periods of 20 years that stocks lose money in real terms. There are 30-year periods where bonds outperform stocks. There are decades where nominal and before fee and tax returns are negative. Stocks do tend to go up over time, but they tend to go up because they are compensating you for the risk that they won’t.

We’ve been critical of ESG funds in the past. Our criticism has been that ESG investing in public markets doesn’t have a large impact on the underlying companies. We posit that changing your spending habits probably has a larger impact than divesting from certain companies. Let’s say you have $50,000 invested in Exxon and you decide to sell to invest in an ESG way. This has zero impact on Exxon. When you sell your shares somebody else buys it and the company has nothing to do with this transaction. However, if you decide to stop buying gas from Exxon, that impacts them directly since their revenue is falling (chances are you don’t buy directly from them and rather through an independent gas station, but we’re simplifying here to make a point). Let’s say you spend $100 in gas a week; this is $5,200 a year that Exxon doesn’t earn. Sure it is a minuscule rounding error in Exxon’s $306 billion in revenue. But it’s a $5,200 larger impact than selling your shares will have.
Another issue with ESG is how do you define ESG? And how much weight do you place on the E (environmental), S (social), and G (governance). We remember sitting in an investment committee meeting in which the manager was pitching an ESG strategy, and a European oil and gas ETF had the highest ESG score. Doesn’t make sense, how can an oil & gas ETF (the antithesis of ESG according to many) have a near perfect ESG score? Well, it’s because they had very strong S and G, and the E had a relatively small weight (don’t ask us why but this is how it worked). So, what you may consider ESG may be different than what we consider ESG or what MSCI (index provider for many ETFs) considers ESG. For example, nuclear power is often excluded from ESG indices; however, there are many who claim nuclear is the energy of the future since it produces zero carbon emissions. Or what about the EU declaring that natural gas is now “green” energy? Or what about the fund linked in the article above that claims to be ESG but invests in defense stocks? If you really want to have an impact, then vote with your dollars by stopping spending on things you think are anti-ESG. Want to protect the environment? Drive less, travel less, donate to reforestation campaigns, etc. Don’t just sell a bunch of stocks and believe that you’re making a change, because chances are you’re not.

We’ve written about stablecoins before. To refresh your memory, a stablecoin is a cryptocurrency which promises to be worth 1 dollar (or euro or whatever). There are two basic ways of achieving this, by holding enough dollar reserves to back the coin 1 for 1. Or via some sort of algorithm that manages the supply and demand of the coin so that it’s always worth $1. There are issues with both. The 1st way there’s always the doubt if the issuer of the coin really has all the assets that back the coin (ex. Tether). Coins that use the 2nd method have a habit of breaking down and collapsing (ex. Terra).
We’re pretty skeptical of crypto in general. As we’ve written countless times before, Bitcoin is merely a speculative asset (not an inflation hedge, not a hedge to the market, etc.) and we haven’t seen any project that we think makes a lot of sense to use in the real world. However, there may very well exist legitimate use cases for many projects (there are thousands of coins, and we are not experts in the area). However, there is so much manipulation, Ponzi schemes, and outright fraud that the whole space is now tainted. Now the US Government is thinking of ways to regulate the stablecoin space. Essentially stablecoin issuers are unregulated banks and some say they should be regulated like banks. Many of these stablecoins offer high yields which are earned by the issuer then lending out their reserves to make a profit. When these loans sour (like with
3AC), many of these issuers can go bust. If these issuers were regulated, yields would probably come down since they cannot take crazy risks with their reserves, but investors (read: speculators) would be safer and more protected from implosions.

This is a very interesting video of a pure arbitrage trade during the 2008 financial crisis. We won’t go into the details of the trade; you can watch the video for that. A pure arbitrage is a trade that you place that has zero risk but has a positive payoff. In theory these trades shouldn’t exist, at least not often. If someone sees a trade like this, they should immediately place the trade and correct the mispricing. However, sometimes pure arbitrages exist, and smart funds can take advantage of them. The trade described in the video happened during 2008 because of liquidity issues. The financial system was crashing, and people only wanted to invest in the most liquid and safe assets, treasuries. Therefore, the fund was able to structure a trade in which they would put zero money down and earn a positive return regardless of what happened; a pure arbitrage.
We often hear the argument that markets are efficient and that stocks should be worth their discounted future value. However, liquidity forces in markets are often very powerful and can trump fundamentals in the short term.

We’re not huge fans of crypto. One of the main problems with crypto is the cult like attitude that has emerged. So called Bitcoin maxis (maximalists) believe Bitcoin will be the future of money and that Blockchain will solve any and every problem imaginable. Many in crypto have taken to such extremes that their arguments often are contradictory. For example, we attended a human rights conference recently in which Bitcoin was touted as a way for refugees to send money back to their home countries and the governments weren’t able to block them. However, in this same conference they were talking about the ill-gotten gains of dictators and how sanctions could be applied on them to prevent them from using these funds, seizing assets, etc. However, if you want to use Bitcoin to allow people to send money without their transfer being blocked, you cannot prevent dictators from using it to move their assets. Therefore, the whole notion of using asset freezes and seizures to punish dictators could not be possible if Bitcoin was a global medium of exchange. These contradictions are rampant in the crypto world, but Bitcoin maxis don’t see (or at least talk about) these contradictions.
We remember the first time we head about Bitcoin. It was in 2014 (when it was worth ~$300) on a
Planet Money podcast about the arrest of Dread Pirate Roberts, which was the founder of the website the Silk Road. This website was used to sell drugs, order assassinations, and a whole host of other black-market activities. The reason that we heard of Bitcoin during this podcast was that Bitcoin was the means of payment for Silk Road. Supposedly Bitcoin’s use has evolved from only being used to pay for drugs, finance terrorism, etc. to other legitimate use cases. However, stories come out all the time of crypto exchanges allowing sanctioned countries to buy and sell cryptocurrencies. The latest under investigation is Kraken, one of the world’s largest crypto exchanges. We’ve said for some time now that many of crypto’s “killer features” are only possible because of a lack of regulation. And as regulators started clamping down on these activities, these killer features would go away. Why did stablecoins pay out such high yields? Because they were unregulated shadow banks, now that regulation is coming, yields will probably fall. Why were you able to create accounts at exchanges without much KYC and AML checks? Because of a lack of regulation. As regulators clamp down on the crypto industry many things will change.

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