Weekly Edition #75

In this edition:

One group of Brits made the trade of a lifetime:

netting $600M the day the oil market broke

During April of 2020, oil futures went negative for the first time in history. To understand why we need to dive into the mechanics on how futures work. A futures contract is a promise to buy or sell a certain asset at a future date. If you buy an oil future contract you are entering a promise with the seller that you will buy X amount of oil barrels at a future date (hence the name futures). Futures can be settled (closed out at expiration) in one of two ways: via physical delivery or via cash settlement. Physical delivery is exactly what it sounds like, you take physical delivery of the product in question. In the case of oil, you need to physically take delivery of 1,000 barrels of oil per future contract. The future contract traded in the CME (Chicago Mercantile Exchange) is for 1,000 barrels delivered at Cushing, Oklahoma. Cushing is a storage facility that has capacity for roughly 76 million barrels.
 
If you buy a futures contract you have to close it before it expires, or you need to take delivery of 1,000 barrels of oil.  During April of 2020, the storage facility in Cushing became full. Since the storage facilities were full, long holders of futures had to get out at any price. As the day went on and investors realized what was going on eventually buyers vanished, and the price crashed and went negative. It ended up closing at -$37. Essentially investors had to pay other investors to take the oil off their hands. In recent years there have been several events which were previously unthinkable, such as negative interest rates and more recently negative prices.

Incentives drive behavior. Fee structures in asset management can help align interests between investors and managers or it can create conflicts of interest. Most fee structures have their pros and cons and rarely is one fee structure completely conflict free. Brokers which charge per transaction have an incentive to churn the portfolio. Performance fee only managers have an incentive to take on a lot of risk to outperform and earn a large fee. Management fee only managers have an incentive to look very similar to the market and focus on gaining assets, even at the expense of strategy performance.
 
There are ways to mitigate most conflicts. If a broker charges per transaction, then they shouldn’t be the ones deciding when to buy and sell. A performance fee only manager should have a large investment in his own fund, so they don’t take huge risks. The linked article talks about an innovative fee structure that tries to incentivize managers to outperform but aligns interests at the same time. The article goes into more detail, but it essentially gives managers the option of purchasing shares in their fund at discounted prices and keeping the investment over the long term, therefore aligning incentives between the manager and the investors.

A black swan is a term in finance that is used to describe never before seen and unpredictable events. Most of the time black swans are associated with market crashes (that doesn’t have to be the case, you could have a positive shock that no one saw coming). There are a class of funds that are specifically designed to pay off in market crashes, so called black swan funds. Hedging market crashes is not especially difficult. If you were worried about a 50% crash tomorrow, you could simply buy put options on the market and be done with it. If you’re right and the market crashes, your puts will pay off handsomely. However, put options are not free, you are buying the option from somebody, and that somebody will charge you a premium for that protection. If the market doesn’t crash then you spent the premium and got nothing in return, essentially your position can go to zero. Therefore, the difficult thing with black swan funds isn’t doing well in a crisis, it’s not losing everything in non-crisis periods. If you consistently buy put options, you’ll do well in market crashes, but you will lose a lot of money whenever the market doesn’t crash.
 
There are many different kinds of black swan funds. A publicly traded example is the
TAIL ETF. This ETF buys out of the money put options (that will pay off if the market falls) and invests the balance in intermediate term treasury bonds. This fund should do well in market crashes and most likely will underperform in up markets. For example, TAIL lost ~14% in 2019 when the S&P 500 was up north of 30%. In 2020 TAIL was up close to 30% during the drop in March, when the S&P was down 30%. However, it gave most of it back and returned only 6% in 2020.
 
Another difficult aspect of black swan funds is that historical patterns don’t always repeat. For example, the combination of put options and treasuries historically has worked very well in market crashes. The puts pay off and the treasuries have rallied in previous market crashes; so, you made money on both parts. However, this year it’s been a different story; treasuries have fallen in line with the market. Therefore, the put protection has worked but the treasuries have hurt instead of helped. These funds should be evaluated in a portfolio context and not as a standalone investment. If you have something that does great in market crashes it might be a valuable addition to your portfolio, even if it loses money overall. If you have the discipline to rebalance then these investments could give you the firepower to rebalance, sell the appreciated investment and buy more stocks when they have fallen.

A common misconception about Bitcoin and Ether and most cryptocurrencies is that they are anonymous and untraceable. In reality most are pseudonymous. If you see a transaction, you only know the wallet addresses involved, you don’t know who’s behind those wallets. However, you can trace transactions throughout the blockchain and see all the transactions that specific wallets have done. Therefore, if you know who owns which wallet, you can see exactly what transactions they have done. In this sense blockchain is perfectly traceable in a way that the traditional financial system is not. There are a lot of misconceptions in cryptocurrencies. And sadly many are taking advantage of people who don’t understand what is really happening in crypto in order to scam them of millions of dollars.

We’ve written before that one of the main dangers of cryptocurrencies is the hype that surrounds them. Oftentimes unsophisticated investors will be drawn into speculating on different coins and will ignore any prudent investing rules. They’ll essentially go all in on a cryptocurrency which promises to pay them X% of yield and then lose it all. If you want to invest up to 5% of your portfolio in the hopes that crypto will skyrocket and make you a millionaire, go ahead. Just don’t forget the key rule in investing: if you don’t know what’s going to happen then diversify (and nobody truly knows what’s going to happen).

Thanks for reading!
 

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