The Investment Scientist

Archive for the ‘wealth management’ Category

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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Let me first define the term “small cap value premium.” It’s an observation (and indeed historical fact up until about five years ago) that small cap value stocks outperform large cap growth stocks in a rather consistent manner. 

In academia, there are two theories attempting to explain it: 1) risk-based and 2) behavior-based.

The risk-based theory was pioneered by Nobel winner Eugene Fama, who argued that small cap value stocks are inherently riskier than large cap growth stocks, thus they deserve higher returns to compensate for higher risks. 

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My long-term readers will remember that since I started writing investment missives, I have always advocated small-cap value investing. That is, holding a broadly diversified portfolio but with a weighting tilt towards small-cap value stocks. 

Up until 2014, the historical evidence is overwhelming. Literally, since there have been stock market data, looking at rolling ten-year periods (see chart below,) there have been only two ten-year periods when small-cap value stocks under-performed large-cap growth stocks, ending in 1998 and 1999 respectively. These ten-year periods corresponded to the dot-com tech-stock bubble in the US.

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I wrote this article in 2007. It’s every bit as valid today as 14 years ago.

I am an amateur pilot. I remember vividly an episode that happened during my training a few years ago. That was a very windy day. Up to that point, I had only experience flying in calm weather. As soon as my Cessna took off, I immediately felt the difference. My plane was tugged and pulled in all directions by crosswinds. I felt like I was losing control of the plane, and fear swelled up from the bottom of my spine to the top of my head. I sat stiffen in the pilot seat and my sweaty palms grabbed tightly at the control handles like a sinking person grabbing onto a straw.

My trainer sensed my tenseness and she asked: “Are you OK?”. Not willing to acknowledge my fear, I asked her instead: “Is it more dangerous to fly in turbulent weather like this?” The trainer smiled and said: “It is not more dangerous to fly in turbulent weather. The plan was built to withstand any turbulence. But occasionally, an amateur pilot would lose his cool and do something stupid. That’s the real danger.

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I promised to continue the GameStop story so here I am. Let me first explain why the broader market dropped about 3% to 4% while the GME frenzy was going on. Remember in the last article, Melvin, a name I will use to denote all the hedge funds that shorted GME, needed about $1.3 billion when GME prices rose from $20 to $30. When GME prices shot up to $420, Melvin needed $55 billion to meet the margin call. Where would they get the money? Well,  they could sell other stocks they hold.  This mass liquidation led to a small drop in the market. Should long-term investors worry? The answer is no, since a liquidity shock like this has no lasting effect. But the saga does reveal a flaw in the system that we weren’t aware of before. More about that later. 

Now in this pitched battle between the retail traders centered around Wall Street Bets and the hedge funds, I am afraid this will end badly for the retail traders. Yes, a few of them may benefit handsomely, turning $50k into $20mm as some of the stories go, but the majority of them who joined the battle when prices crossed $200, $300, and $400 may lose everything. In the end, prices will come back down to the stock’s fundamental value which is likely in the single or low double digits. After all, Melvin was not stupid.

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Before I tell the story, let’s get a few concepts clear.

Short Sell (short) means selling shares you don’t actually own. Instead, you borrow them from the brokerage to sell, but you have to buy them back at some point in the future, hopefully at a lower price, to pay back the brokerage shares you owe. To guarantee that you have the money to buy back shares you owe at all times, the brokerage requires you to have a maintenance margin of 130% of the value of the shorted shares to keep the position open. If you fall under the margin requirement, you will get a margin call to post additional money. Should you fail that, the brokerage will close your positions. This is done by buying shorted shares in the market using your money in the margin account. This forced action can cause a short squeeze. I will give you the definition with an actual example of GameStop (GME).

Just two weeks ago, GME was being traded at around $20. Some big hedge funds like Melvin Capital (Melvin), thought it should be worth only $5, so they began to short the stock. At one point, the short interest ratio, the number of shorted shares relative to the number of outstanding shares, was 140%. Since GME has about 70 million shares outstanding, Melvin shorted nearly 100 million shares of GME. Apparently, a portion of those shares was borrowed and sold twice.

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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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