The Investment Scientist

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Yesterday, when I had a lunch meeting with the chief scientist at Fannie Mae, our conversation quickly turned to inflation.

My view of that is more pessimistic than the Fed and most mainline economists. Somehow, these economists seem to have forgotten a basic economic tenet – the rational expectation theory. This theory, to put it in layman’s terms, basically says that on aggregate, what people expect to happen will happen. That’s why Fed officials have long been extremely careful about what they say that could change people’s expectations. 

Today’s Fed under Jerome Powell has been much less careful. Here are the three acts of the current Fed that have crushed the expectation that inflation will stay low and stable. 

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I had a blessed 2021! Here are the highlights.

1) Finished all my Oxford courses.

2) Produced a Showstopper improvised musical show for my Oxford classmates at Oxford.

3) Visited the Balkans, especially “the Bridge over Drina.” Learned about its fascinating and tortured history.

4) Took my kids to many Western European cities/towns.

5) Continued my hip hop adventure with Doug. Now I can more or less rap freestyle!

6) Started learning German. With help of a fantastic teacher Kat, I can now speak broken German.

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In my last newsletter article, I explained what tapering means and how that would affect the market. At the end of the article, I opined that the Fed’s leisurely pace of turning off the money spigot may not be enough to turn the tide of inflation.

It now appears the Fed agrees with me. The latest announcement from the Fed has dropped the word “transitory”, signaling its recognition that inflation is here to stay. Not only that, but the Fed’s taper timetable has been expedited. The original plan was $15B less money “printed” every month, with July being the month that money printing will come to an end. The new timetable is to end money printing by March. After that, the Fed plans to raise interest rates three times.

The Fed is the banker for banks. When the Fed raises interest rates, banks have less incentive to lend out money since they could easily make a profit by just parking their money with the Fed. This is the traditional way of reducing the amount of money in circulation. 

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Recently, Fed Chairman Powell signaled that the Central bank will begin the process of “tapering”, and in fact may speed up the process given the recent inflation reports. What does that mean? How would that affect investors?

A little bit of background
Since the onset of the pandemic, the Fed has engaged in “unlimited” quantitative easing, a euphemism for money creation. The money base has ballooned from about $4T to $7T. (T here means trillions.) In other words, about $3T worth of new money was created. As of right now, this process has not stopped. Every month, another $120B is being created. (B here means billions.) 

Where did all that money go?
This torrent of money is rushing into all manners of markets: stocks, bonds, commodities, real estate, crypto, labor and even our daily groceries, making all prices go up, though to differing degrees and extents. As investors, we all benefit from the Fed’s action, however, as consumers, we will suffer, if we are not already.

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Yesterday, a young tech worker from the West Coast signed up for my 2nd opinion review. He just had a very successful exit from an IPO, and is now sitting on $20mm worth of company stock, much of it capital gains. Morgan Stanley is pushing strongly for him to put his money into a QOF, and he wanted my view on that. 

I happened to have just written a paper on this topic for a Oxford Private Equity class assignment, so I have done some pretty in-depth research. Mindful that most people don’t have the patience to read a long essay like that, I will summarize my findings as succinctly as possible here. 

What is a Qualified Opportunity Zone (QOZ)?A QOZ is an economically depressed area that can’t attract investments on its own. The Tax Cut and Jobs Act of 2017 established this designation and certain tax benefits for investments into these areas.

What is a Qualified Opportunity Fund (QOF)?A QOZ is a private investment vehicle (in the form of a partnership or LLC) that invests in QOZs.

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I gained a lot from my Oxford experience. Some of the gains are for me personally, some of the gains are for my business, and yet others can help me better serve my clients. I would count the latter as my clients’ gains.

The biggest gain undoubtedly came from Professor Sussman’s macroeconomics class. There I learned all the intricacies of macroeconomics, including how monetary policy is conducted. The class helped me understand a language called “Fed speak.” For instance, in March last year, when the entire stock market was in a tailspin, the Fed came out with an announcement of “unlimited” QE. The me without the Oxford education would have not understood what that meant. But alas, after the macroeconomics class, I knew exactly what the Fed was planning to do and understood its implications for the market. Thus in the depth of market despair, I was confidently rebalancing my clients’ money into stocks. Sure enough, the market snapped back quickly and has been rising ever since. 

Back then I wrote a newsletter article where I informed you:

With this much liquidity, an equity market rally is almost certain …

You can read the entire article here, “Fed’s Unlimited Asset Purchases: What That Means for You and Me?

The second biggest gain came from a part of the microeconomic class. I understood micro far better than macro, but I still learned something new from that class. In the past, the consensus had been that firms manifest a decreasing return of scale. That means as firms get bigger, it’s harder for them to make money at the same rate. Thus smaller firms are usually more profitable and often give investors better returns over the longer run. 

However, the latest research has discovered that with the advent of the internet, some big firms achieve the so-called network effect. That is, the bigger they get, the stronger they get and the more money they make. Think of Facebook, Google and Apple. These types of firms achieve the so-called increasing return of scale unheard of before.

This led me to move a substantial chunk of my clients’ money into stocks with the increasing return of scale characteristics. My clients’ portfolios have benefited since. 

The Behavioral Finance class also taught me a lot. It didn’t really teach me anything new, rather it confirmed my belief that our behavior as investors is much more decisive than whatever investments we select. It feels good to get a stamp of approval from Oxford and I’d like to call that the third biggest gain for my clients. 

I have personally benefited from the clarity I gained at Oxford as well. Before I went, I wondered if I should turbo-grow my business to multiple billions of dollars with hundreds even thousands of clients. Now I have the answer. I will keep the business unique, focusing on serving a small number of clients very well. Instead of growing my business, I’d rather grow myself as a person. It is also the best way to grow my clients’ wealth by focusing on them!

Schedule a 2nd opinion financial review, buy my wealth mgmt books on Amazon.

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Last Saturday I completed my executive MBA study at Oxford. The whole thing actually started quite serendipitously. A client of mine who is a physician studied there and he liked it so much that he encouraged me to apply. Today I’d like to share some funny moments on my journey.

As part of the application process, I went to Oxford for an interview. I booked a student dorm room at Sommerville college, and when I checked in, I was mesmerized. The dorm room looked and smelled like it was right out of a Harry Potter movie. The adjacent canteen looked like the Great Hall at Hogwarts, with walls adorned with huge classical paintings of accomplished women alumni. 

That night I was the only resident in the entire building, and it didn’t take long for me to notice that the bathrooms were not marked by sex, and in fact there were no male bathrooms. Later I found out that Sommerville is the first girls’ college at Oxford and Margaret Thatcher herself graduated from there. 

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Last week I completed the Venture Capital class at Oxford, and I have at least two take-aways  I’d like to share with my readers. Today, let’s talk about SPACs since a few of you have asked me if we should invest in those, and before I had not felt qualified to answer the question.

What are SPACs?
The name SPAC is a shorthand for the Special Purpose Acquisition Vehicle. These are companies backed by famous investors/entrepreneurs (sponsors) that raise a sum of money via IPO then search for a private company to buy.

For venture-backed companies that want to go public, this is a great option since they don’t have to go through the IPO process – roadshows, book building, the whole nine yards. All they need to do is to sell to a SPAC. 

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This is an article I wrote fourteen years ago that was inspired by Daniel Kahneman’s Nobel Lecture “Maps of Bounded Rationality.” Here I will repost it without changing one word – I am proud of the evergreen nature of my articles. At the end, I will make a few additional comments in red that include new insights from the last fourteen years. 

Do you know that the top three one-day drops in Dow Jones happened in October? On the 19th of October 1987, Dow Jones fell nearly 23%, making the day the worst day in the US stock market history. It was followed by the 24th and 29th of October 1929, when Dow Jones fell 13.5% and 11.5% respectively, ushering in the Great Depression. These events are commonly remembered as the crash of 29 and the crash of 87.

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This is an article I wrote fourteen years ago almost to the exact day. Here I repost it without changing one word. I do make a few additional comments with red letters.

On July 17th, the S&P 500 reached its peak after breaking a string of records. In a two week time however, both the S&P 500 and the Nasdaq Composite have lost 7.7%. The index that represents smaller stocks suffered a bigger loss of more than 10%. Are you feeling any pain and anxiety? I know I am.

The market is breaking new highs, but it can turn on a dime. Understanding how you will feel in a falling market is very important.

Before I talk about how I deal with the pain and anxiety arising out of the market tumble, I’d like to first talk about Equity Premium Puzzle and Myopic Loss Aversion. These are weighty academic terms, but they would help us understand our psychology and how it could drive us to do stupid things.

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Last week I shared an example of how you could still lose money on an investment that gives you a 20% average annual return. I ended the article with five questions:

  1. Can the average return tell you if you will make or lose money?
  2. Can the average return tell you how much money you make or lose?
  3. What else determines if you make or lose money?
  4. Why do hedge funds love to use average returns?
  5. Why do I use asset class diversification to reduce client portfolio return variability? (Note that this will make the return number look smaller.)

Here are the right answers:

  1. No.
  2. No.
  3. Return variability or volatility. It is also called volatility drag – the higher the volatility, the lower the return. Here is an article on this subject I wrote 13 years ago.
  4. It’s great for marketing.
  5. One word: I am a fiduciary. (Ok, four words.)
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Sure you can! Look at the following stylized example.

Hedge Fund A has a first-year return of 100%, and a second-year return of -60%. The hedge fund’s average return is (100-60)/2 = 20%. But if you have invested $100k in this hedge fund, by the end of the second year, you will only have 100*(1+100%)*(1-60%) = 100*2*0.4 = $80k. In other words, Hedge Fund A gives you 20% average annual return, but you still lose $20k or 20% of your money!


What gives?! Let’s look at the following 6 investments, all of which have a 20% average return. Some are profitable and some are not. All assume an initial investment of $100,000.

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Today I finally finished the Oxford class on Private Equity, and I’d like to share with you, my readers, some of my takeaways.

Long-time readers of my newsletter should know that I have long advised against investing in private investments unless 1) you know the business and 2) you have a measure of control. The reason for this is that private investments are not under the purview of the SEC, and thus provide a fertile ground for conflict of interest. After the Oxford course on private equity, I feel completely vindicated.

Some of my readers, if you are wealthy enough, will be approached with private equity investment opportunities. You will be presented with mouth-watering return numbers. My professor called these numbers complete “garbage,” they can be manufactured (but not fabricated.) Fabricating numbers is against the law, but manufacturing numbers is not, and there is only a hair’s breadth separating them. Next time you see a number like 36.8% annual return, think “manufacturing” and don’t waste your time! I will show you how they manufacture numbers in the next article. 

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Recently, Dimensional Fund Advisors (DFA,) a mutual fund company whose funds I use a lot for my clients, replaced its Tax-Advantaged US Core 2 Equity Fund DFTCX with an ETF DFAC. In this article, I will explain how a mutual fund can achieve tax-advantaged status, and I will further explain how it is even more advantageous to move to an EFT.

A mutual fund is simply a pooled investment vehicle. Many folks’ money is pooled together in the fund, and the fund manager invests it. As a fund investor, you may still hold the fund and therefore there is no realization of capital gains on the portfolio level. But on the fund level, there are still capital gains because of trading. These gains are passed down to each individual investor, and they must pay taxes on them. This is despite the fact that they have not sold the fund. 

A tax-aware fund manager can reduce this tax burden on the fund’s investors by trading less, especially by deferring the realization of gains. That’s why a fund’s turnover is an indicator of a fund’s hidden cost. The higher the turnover, the higher the transaction costs and tax burden. 

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Last week, I wrote an article on inflation and stock returns. This week I will continue the theme but study it from a different angle. 

Specifically, last April the inflation rate was 0.3%, but this April it was 4.2%. In one year’s time, the inflation rate has gone up nearly 4%, what does that portend for the stock market? Again, Taro helped me run the numbers and we came up with this scatter plot relating inflation changes to stock returns. Please look at it and see if you can draw some inferences yourself.

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Since I started investment management fifteen years ago, I can’t recall a time when the risk of inflation is as pronounced as it is today. Since the onset of the pandemic, the Fed has created $5 trillion worth of money. Now, as the economy is reopening, the torrent of money is gushing into circulation, lifting inflation to 4.16% in April alone and possibly higher down the road. How the market behaves is our study today. 

I asked Taro to look up Bob Shiller’s dataset and Kenneth French’s dataset and run a correlation analysis of stock returns vs inflation. Here is the result in a chart along with my observations. 

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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