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A product only a banker could love

May 25, 2010 in Finance,Internet

There’s a lot of excitement about just-launched startup Betterment, but I’m very wary. At best, it’s an example of “bad” financial innovation. At worst, it’s a straight up scam. It goes to show that it doesn’t take complexity and structured products to pull the wool over investors’ eyes; all you need is a website and the adoration of an unsaavy site like TC.

Here’s the pitch: Betterment provides a “better savings account” which consists of a mix of two portfolios: one an extremely diversified basket of stocks and the other comprised solely of TIPS. Users transfer money to Betterment, choose an allocation between the two portfolios, and are expected to treat the resulting exposure as if it were a savings account.

Please pay close attention: you’d have to be out of your mind to consider this a savings account! Savings accounts pay interest and don’t decrease in value; that’s why they are for saving. Betterment is nothing more than a brokerage account in sheep’s clothing, giving you access to a single equity product and investing the balance of your cash in TIPS. And don’t make the mistake of thinking your Betterment account is principal-insured. It can go to zero just like any equity portfolio. So a savings account this most assuredly is not.

And paying for this sort of account? Even more insane and wholly unnecessary. The only real service the site provides is an automatic reallocation but only to one risky asset, so there’s no justification for paying the indicated levels — or anything at all. Yes,there’s a price to be paid for convenience, but it’s well below this level.

Stocks Can Go Down

Betterment discloses the fact that their portfolio can lose money deep within their website – it takes a couple clicks to reveal the disclaimer, in the section comparing Betterment to traditional bank accounts:

While your Betterment account is as easy to use as an online savings account with a bank, there are a few main differences. Although most bank accounts are guaranteed not to lose value, there is a possibility that your Betterment savings could lose value depending on market conditions.

At the same time, a Betterment account is better than a bank savings account because you could receive higher returns than a savings account.

Notice that you could receive higher returns — nothing guarantees it. Another section of the FAQ addresses the downside risk specifically:

Like all market investments, the securities you own in your account are subject to market risk. If the markets are up, your balance will grow. When markets are down, your account will lose money. Fluctuations are especially hard to predict over the short term, but historic data shows that over the long term your investment is likely to increase.

Though there is an obligatory “past performance is no guarantee of future results” notice at the bottom of the section, they actually invoke historical returns as evidence for expected results! You simply can’t use phrases like “likely to increase” when pitching an investment. It’s unethical by any standard.

Portfolios Are Not What They Seem

Betterment provides two portfolios: an “ultra-safe and secure” TIPS portfolio and a highly-diversified equity portfolio “which allows you to invest in literally thousands of companies all at once. It’s like owning a little piece of every public company in America.”

First off, despite being backed by the full faith and credit of the US Government, TIPS can lose value. Bond yields are only locked in if you hold them to maturity. Indeed, the Betterment TIPS portfolio has experienced a drawdown of 10% in the last 6 months. I’ve never seen a savings account do that before – but I’ve seen an awful lot of people freak out (not to mention a few senators) when stocks fall by a similar amount.

An article published yesterday notes that “the company has already provided returns for its beta users. While the S&P 500 is up 23 percent on the year, Betterment’s stock portfolio is up 29 percent across the same period, which is a significantly higher return than a savings account.”

I have no idea what universe the author is in, thinking the S&P is up 23%. Maybe he meant to refer to 2009, in which the SPX was up about 26.5%. Or maybe he was referring to Betterment’s beta period. I’m not sure, but here’s what scares me about those numbers: Betterment claims that its stock portfolio is extremely diversified — so where is that extra 6% coming from? A fully diversified portfolio should have the market return.(Edit: David Haber points out that I should specify I’m referring to a value-weighted diversified portfolio, in order to be Markowitz-compliant.) Examining the actual holdings, I see that the portfolio is skewed heavily toward a value style of investing — not necessarily good or bad, but something you might want to know. Especially when the S&P’s actual YTD return is -3% and counting. Extrapolating Betterment’s beta on that return means the stock portfolio’s YTD performance is somwhere in the -4% range. Some savings account.

Fees

And here’s the kicker — Betterment makes a big deal about their simple fee structure:

When you change your allocation between our two investment baskets or transfer money to your linked account, there are no transaction fees. Our low, straightforward advisory fee—0.9% annually of your average balance—covers everything. So you can easily access your money whenever you want, without worrying about the cost.

But you’d better be worried about that cost — it’s obscenely high! 90 basis points of assets to invest in the aggregate market and government securities? I’ve invested in actively managed mutual funds which charged half that amount!

This is where Betterment looks like a scam to me. The company takes investors’ money, places it in ETFs, and collects a fee. But they’re not even choosing a portfolio for you — they’re just handing off your cash to the ETF. And those ETFs charge their own management fees, which you’re on the hook for as well (implicitly). So if you’re already paying a separate fee to the portfolio manager, what on Earth are you paying 90 bps for? While claiming to cut out the middleman, Betterment is nothing more than a middleman itself.

If you’re the do-it-yourself type, you can form an identical portfolio for far less. Charles Schwab will let you transact ETFs for $8.95 flat (and that’s not an annual fee). Moreover Schwab will let you trade TIPS for free!

Once you own those ETFs, the expense ratios are significantly less than 90 basis points, ranging from 7 to 25 bps (there’s one ETF described on the website, an iShares S&P 1000 Value ETF, which I simply can’t find…). You don’t really need all the different ETFs that Betterment holds to achieve full diversification — they’re all indices anyway. The Vanguard is the cheapest at 7 bps, and tracks every common stock regularly traded on NYSE, AMEX and NASDAQ. It’s hard to diversify any more than that. Buy that ETF for yourself and you can keep the 83 bps that you’d otherwise give to Betterment for absolutely no reason.

If you don’t want to deal with trading actual TIPS bonds, there’s an ETF for that as well. You could use the very same one that Betterment uses, in fact. Its expense ratio is just 20 bps.

Now, Betterment is providing a real service: they will automatically rebalance your portfolio and maintain your specified allocation. It’s not worth even close to 90 bps, though, because it can be done for almost nothing (though not with a nice “speedometer” graphic), aside from small transaction costs to a company actually providing a financial service. For example, at Schwab’s commission rates, you would have to make 100 rebalancing trades a year on a $100,000 account before Betterment’s fee became attractive.

Conclusion

This sums up the Betterment inspiration:

“When you go to a broker you have to pick among a menu of funds and stocks that are available,” said CEO and founder Jonathan Stein. “It’s an overwhelming experience for many people, even Columbia MBAs.”

I’m not sure what the arbitrary Columbia reference is for, but it is definitely true that choosing a portfolio can be intimidating. What I don’t get is why anyone in their right mind would pay almost 1% of their assets to a company which is implementing a passive market strategy! You already know what they’re going to invest in, and I’ve demonstrated that you can do it yourself for a fraction of the cost. This is anti-efficiency. This is an obfuscation of clarity.

I get it, from a certain angle – there’s a CAPM-style appeal. Betterment lets you choose between a risky portfolio and a riskless portfolio: a “roll your own Markowitz-optimal portfolio” sort of paradigm. I’m sure there’s a market out there for people who desperately want to put their money in stocks (because they’re doing so well this year…) but don’t know how, and the stripped-down simplicity of Betterment’s site makes that possible for them. I think they’d be insane to pay 1% of their wealth for that simplicity, but that’s the internet for you.

Stein goes on to say:

“We want to take this really big. We want to make investing accessible for people as soon as possible.”

Oh, I’m sure they do. Highway robbery is so much easier when your customers line up to be frisked.

Addendum

If you’re looking for a Web 2.0 banking solution, keep an eye on BankSimple. I won’t vouch for them directly because I haven’t actually seen their product yet, but it looks very promising and I’ve had the chance to talk shop with one of the founders, who definitely knows what he’s doing.

And if the thought of online-only banking doesn’t terrify you, I can’t recommend Charles Schwab highly enough. Their customer service is beyond outstanding (I’ve never even waited on hold) and I have yet to be charged a fee for anything at all.

(Via Michael Broukhim)

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Stock is more efficient than options are more efficient than stock

November 18, 2009 in Finance,Risk

There is a very interesting debate taking place on the profitability of options as opposed to the underlying stock. It originates in this post from Ultimi Barbarorum on options volume following the Palm/3Com announcement, and continues in the comments on Felix Salmon’s coverage of that post.

The crux of the argument is the spike in options volatility immediately preceding the merger announcement, which many took as a clear sign of insider trading. Baruch argues that options are notoriously volatile, so one spike is hardly a smoking gun, and I agree (see also: superstitions regarding trading on option expiration days). However, I echo Felix in noting that it’s very hard, therefore, to draw any conclusion about insider trading whatsoever. Baruch’s second point is that if it were insider trading, it was misguided – the insiders could have made more money and attracted far less attention by trading the underlying stock rather than the options. This is where the debate lies – and I confess up front that my immediate impulse was to say “that can’t be right.” In fact, it could be right, depending on your point of view.

(p.s. hats off to Baruch for introducing his post with “Before the Zero Hedge folks get the pitchforks out, let’s stop and think a bit.”)

Baruch writes:

Had someone concrete knowledge of the 3Com deal, it would be far more efficient to buy the stock. The most important of the “Greeks”, as options dudes call the panoply of statistics surrounding options, is “delta”, the rate of change in the value of the option relative to the value of the shares (it’s a function of volatility, time to expiry, a whole lot of stuff, don’t trouble your head), and this is always less than one. 3Com options buyers made far less money on the takeover by buying options than they would if they had bought the stock.

It will be instructive here to discuss delta – I know some of TGR’s readers are already familiar with concept, and I hope you will excuse this detour.

“Delta” is a mathematical (as opposed to financial!) derivative of the option formula, as described by Baruch – but it is easier to understand as a “hedge ratio.” It tells you how many shares of stock you need to hedge your exposure to an option (I’m going to assume from here on that we are discussing calls). To see why, run back to the math for one second and consider that delta is the amount that the price of the option will rise if the stock price goes up by $1 – ok, now ignore the math. If the option is way in the money and trades at its intrinsic value, then it will gain $1 for every $1 the stock rises – a delta of 1. It the option is at the money, then its as likely about whether it will ultimately pay off at all, and so it only gains $0.50 for every $1 the stock rises – a delta of .5. Thus, if you want to hedge your option exposure, you would short [delta] shares for every option you hold. Delta is always less than 1; no option will gain more than $1 for every $1 the stock price rises.

The key to this delta business is that as long as delta is less than 1, you need to short fewer shares than the amount you control via options in order to hedge your option exposure. Put another way, it takes more options than shares to create the same exposure (on a per-share basis) to the underlying stock. If the stock price moves up, the dollar gain from holding that stock will be greater than the dollar gain from the options, hence the argument that stocks are “far more efficient” than options.

The closing price for COMS on November 10th, the day before the option purchasing frenzy, was 5.41. The $5 November calls cost slightly more than their intrinsic value at $0.55, trading with a delta of 0.72. On November 12th, the stock closed at $7.46, representing a gain of $2.05, whereas the options finished at $2.50, gaining just $1.95. Share for share, the stock outperformed.

However, shares controlled is an poor metric for comparing investments. This is particularly true for options, where you may not know until the day they expire if you actually control those shares or not! Instead, for risk management purposes we think of the number of shares the position is likely to control, given the current state of the world: the probability-weighted number of shares. Unsurprisingly, it’s the same as the number of shares it takes to delta-hedge the position. From this observation, a nice property of delta is revealed: it may be roughly interpreted as the probability of an option finishing in the money.

The important philosophical point here is not to make the mistake of thinking that the number of options you buy is equal to the number of shares you own – that’s only true the day they mature in the money. To set up the same exposure in options as we have with shares, at the time of purchase, we need to buy a few extra options. Specifically, for the November calls with a delta of .72, we need 1/.72 or 1.39 options for every share. Run the numbers and you’ll see that this results in a final profit of $2.71 on the option side, vs $2.05 for the shares. If an insider bought options on a delta-adjusted share basis, he’d find the options more profitable than the stock.

(If you constantly adjust the number of options to correspond to the prevailing delta, you’ll wind up making $2.05 on your options – this process is called dynamic delta-hedging [that's a real aside for this post, because the discontinuity in COMS stock price would make the rebalancing futile].)

So, on the basis of shares-at-maturity, stock yielded a better dollar profit. On the basis of shares-at-trade, options would have been preferable. There’s an argument to be made that, as an insider, you know the options will finish in the money, so shares-at-maturity is the right way to consider it. But there’s a third exposure metric: capital at risk.

You can look at capital at risk as either 1) the maximum loss you could experience OR (if you’re an insider who knows the trade will be profitable) as the opportunity cost of capital. This is very straightforward to explain: those options only cost $0.55; the stock cost $5.41. The percentage gain on the options is 355%; for the stock it’s just 38%. If you consider your exposure in terms of dollars invested, rather than shares controlled, you’d find the options a far better bet: they cost almost 90% less than the stock but return nearly as much per contract! So for every dollar you could put into the stock, you could instead put into options and return 10x as much. Options, from this perspective, are far more effective.

So this all depends on how you look at your risk and exposure. Baruch assumes that his insiders want to control a certain number of shares, and from that perspective they should absolutely have transacted stock instead of options (assuming that, with their perfect knowledge, they skip over the delta-adjust share argument). Personally, I would look at it from a capital at risk perspective – if I’m willing to spend $5.41/share to make $2.05, why not put that to work in options and make $19.18?

It all depends on your perspective – both answers could be correct, given some set of portfolio constraints and different definitions of risk/exposure.

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Dilution in action

July 17, 2009 in Finance

A lot of sites are reporting Bank of America’s year-over-year income comparison without batting an eye:

Bank of America posted income of $3.22 billion, or 33 cents a share, down from $3.41 billion, or 72 cents a share, a year earlier.

The number wasn’t particularly surprising (EPS slightly beat, revenue slightly missed) but couldn’t anyone spend a paragraph on how $3 billion a year ago was worth over twice as much per share than it is today? The closest was the WSJ, which supplied a single sentence:

The company had 64% more shares outstanding in the most recent period amid its capital-raising efforts.

It’s not a complicated matter, but here the effects of shareholder dilution are dramatically illustrated; this is the real price paid for government aid. The dollar figure is important as well, but now it takes twice as much profit for each individual shareholder to benefit as much as they would have a year ago.

Denominators matter.

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JPM, AXP ask taxpayers for money to pay back taxpayers

June 1, 2009 in Finance

Almost like a Ponzi scheme, but not quite: JP Morgan and American Express plan to issue common stock in order to pay back their TARP funds.

Essentially, the two firms are going to sell parts of themselves to taxpayers in order to increase their cash, which will then be used to buy back, yes, parts of themselves that taxpayers already own.

What does that remind you of? Some sort of scheme in which funds from the newest investors are used to pay back older investors? But of course I’m oversimplifying, as there must be reasons why this actually makes sense:

Taxpayers currently own preferred stock, so exchanging that for common stock would move taxpayers to a more junior position in the capital structure. This makes life more simple.
Preferred stock has a fixed coupon; common stock pays a dividend only at the discretion of the company. This reduces the obligations of the firm.

But above all, the preferred shares are really held by the Treasury, and consequently come with a whole bunch of regulation and (retroactive?) restrictions even though the shares are non-voting. These firms would opt out of TARP at a massive loss, if they could, and taking money from taxpayers to pay off other taxpayers is the next best thing. So stay tuned, because the Fed will announce next week whether firms are, in fact, allowed to pay back TARP. It is most likely that the amount of capital being raised in these offerings is the amount firms must demonstrate they are capable of raising in order to return the TARP funds.

The Fed is essentially mandating that firms demonstrate the ability to raise capital privately, without having it forced upon them. At least it’s not as bad as issuing debt to pay a dividend.

(Minus 1 to Bing for making it absurdly difficult to get news on these companies. Two clicks, one of which is the nondescript “more” button?? Dangerously close to a dealbreaker.)

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Indecision.

June 1, 2009 in Finance

Stock price of GM the day it files for bankruptcy (unchanged):

Stock price of Lear the day it skips an interest payment (up 14.5%):

Needless to say, both charts are from today. I’m reminded of the quote from the otherwise-terrible Episode I:

So this is how liberty dies. With thunderous applause.

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Quick thoughts: stress tests and such

May 6, 2009 in Finance,News

Front page of the NYT tonight: “As Stress Tests are Revealed, Markets Sense a Turning Point.”

I know I’m a cynic, but my first thought was “…which way?” Is it even possible to turn upward after a 40% rally? Sure enough, the article is quickly laced with the caveat “All of this assumes that the economy does not take another turn for the worse.” And then I have to half-seriously wonder: but wouldn’t that also support the title statement?

What this means is that the “second derivative” viewpoint is really taking hold. I remain unconvinced. The first derivative is what matters.

And a final thought: if the government’s investment gets converted to common stock, how does it get paid back? The bank can no longer simply hand over the money it was loaned and be done with it; it will now have to buy out a large equity stake. Do taxpayers get to vote on when that happens?

So many questions…

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The Short Squeeze

April 30, 2009 in Finance

It is a favorite chorus of the anti-CDS crowd that CDS can make it more difficult for a company to survive, since bidding up CDS prices can affect the firm’s cost of borrowing.

This is about a hair’s width away from the oft-cited argument that “short selling is bad because it drives down stock prices,” a view that has was disproven in a massive 2005 study as well as multiple studies (pdf) showing the recent ban was actually harmful, not to mention market participants ultimately declaring it a failure.

However – in fairness – there is one time where short selling, or taking a short position more generally (such as through CDS), makes an indisputable impact on the underlying security: the short squeeze.

What happens when investment firms that have bought (potentially) limitless amounts of insurance on another company’s debt need to hedge their short position? They must compete to buy the relatively few tangible assets that can provide that hedge: the company’s bonds themselves. And this bidding war is ferocious. CDS driving a company’s spread wider is a bit of a wags-the-dog situation. But massive demand for a company’s bonds, that’s real. Moreover, it has been a major driver of the recent credit rally, which in turn fuels the equity run.

The most dramatic example of a short squeeze in action is of course Volkswagon, which gained 500% in one day last fall and was briefly the most valuable company in the world after a massively short investor base suddenly realized there weren’t enough shares to go around (Porsche had conveniently purchased most of them, and would end up booking a profit). But here’s the key: if short sellers can drive stock prices down, then surely VW – with one of the highest short to shares ratios ever – would have experienced some sort of price depression. But no, the stock hardly dropped in the months preceding the spike. Instead, this particular example of financial product failure resulted in saavy VW employees becoming millionaires overnight.

One datapoint does not a proof make, but look at today’s credit market, or even the recent equity markets rise on decreasing volume, and you’ll be unable to ignore the power of short covering to drive real asset prices higher. The market works on supply and demand; derivatives have a seperate market and so do not affect underlying asset prices except to the extent that people use derivative prices to extract risk information which informs their demand for the underlying. But whenever the derivative market and tangible market intersect, look out! If I own an arbitrary number of CDS and suddenly I need bonds to cover, the market’s normal mechanics will be disrupted. Even the VW example represents a perversion of supply and demand – Porsche was slowly buying up all the shares while other investors were shorting them, restricting supply dramatically. I remember headlines at the time which announced Porsche was actually releasing shares just to placate shorts who needed to cover.

Ultimately, if capitalist markets represent the method by which capital is most efficiently allocated and required returns are most efficiently expressed, then a long-only market is hardly the epitome of that ideal. But as long as companies can point the finger at “security manipulation” instead of their own performance (expert witness: bank stocks declining despite the short sale ban), we will continue to have this debate. Not that any company complains when the short squeeze pushes them higher. Instead, they just issue debt and stock, a behavior which lately has been married to the highest rate of insider selling in year.

So the next time someone tries to claim that CDS, or short selling, can have an adverse impact on asset prices, don’t throw study after study at them which demonstrates otherwise. Just point out that to the extent their argument is true, it’s effect is much more dramatic on the squeeze side – the upside – than where their complaint lies.

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The math (and myths) of leveraged ETFs

April 20, 2009 in Finance,Math

Leveraged ETFs are vehicles which provide non-recourse leverage on various sectors or strategies. For example, every day the double-inverse financials SKF returns roughly -2 times the daily return of the DJ Financials index.

These products are a favorite of mine not simply in a speculative framework, but in a quantitative one. Many people make the mistake (and it can be a serious one) of assuming that a double-levered ETF should return twice as much as its underlying index over a given holding period. That’s incorrect – the ETF’s only return their stated multiple for one day. After that, the ETF has to relever itself in order to maintain it’s mission. This is because the ETFs typically acquire leverage through the use of total return swaps (TRS). A total return swap is a swap in which the two counterparties agree to exchange the exact same cashflows as if they had traded a security. For example, counterparties A and B enter into a TRS on some stock Z, struck at $100. A pays B $1 for every dollar Z goes above $100, and vice versa for every dollar under. It is exactly the same as if B bought Z from A, except that no capital had to be put up (thus, it is a levered trade). The important thing to note is that each unit of a TRS provides a dollar return, not a percent return. Owning twice as much TRS means you make $2 for every $1 the stock goes up. Therefore, the ETF must rebalance to maintain it’s constant multiplicative exposure.

Here’s an example. The underlying index X starts at $100. My double levered ETF E also starts at 100 and because it is double levered, it must own twice as much TRS as it would hold stock in the underlier. Let’s say E has $100 in assets, so it owns 200 units of TRS. On the first day, X increases 10% to 110 as each share gains $1. E increases 20% to $120, as expected, since each TRS gains $1 as well. The following day, X increases another 10% to 121 (each share gains $1.10), and we expect E to grow 20% to 144 ($24 gain). However, E only owns 200 units of TRS, which means it will earn only $22 dollars as each TRS gains $1.10. In order to realize a $24 gain and return its target 20%, E would have to purchase 20 more TRS at the end of the previous trading day – and that act is the relevering.

It is especially interesting to note that E must re-lever in the direction the underlier moved regardless of whether the ETF is long or short. Above, the underlier kept increasing in value – and E had to purchase more and more to maintain its leverage ratio. Conversely, had the underlier fallen, E would have been selling into the decline. As levered ETFs attract more and more assets, this end-of-day relevering can have market impact, enhances gains and exaggerating losses.

The second key fact about levered ETFs is that they exhibit a strong downward drift, moreso as the leverage increases. This is why if you plot an index against it’s triple-levered inverse ETF, both can decline in value over time despite the ETF’s mission of returning “opposite” results. To see why, consider what happens when an index moves up 10% and then down 10%: it doesn’t go back to where it started, it actually loses 1% (order of the moves does not matter, either). It goes from 100 to 110 to 99, or if you prefer from 100 to 90 to 99. Either way, 10% up and 10% down is not an even trade.

Now lever it 3x. Before, you lost 1%. Now, shouldn’t you lose 3%? 10% up and 10% down become 30% up and 30% down, or 100 to 130 to 91, for a loss of 9%. You didn’t lose 3 times as much, you lost 3-squared times as much. And we can easily extend this to a case where the underlier is up but the ETF is down: 10% up and 8% down, which results in a 1.2% gain for the underlier, but a 1.2% loss for the ETF. More complicated examples are easy to construct, and here is a real-world one of the SKF vs its underlier, the DJ Financials index. The index is off 66%, while the double inverse ETF is off 16%:

levered-etfs

And if this discussion hasn’t been fascinating enough, Barclays recently put out a recearch piece delving much further into the math behind these elusive securities and exploring the impact of the relevering process.

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Bear Stearns is worth slightly less than A-Rod

March 16, 2008 in Finance,New York

Obviously the news of the hour is that J.P. Morgan is buying Bear Stearns for $236mm, or just $2 a share, meaning the firm is worth only a fifth of the value of its own midtown headquarters. The Yankees paid more for their third baseman.

More gravely, despite the WSJ headline, there is no “rescue” here. Bear has a book value of $84; the $2 price appears to be more of a formality than anything else. JPM is opportunistically buying the profitable prime brokerage business for a fraction of what its worth; getting the rest of the company is a bonus. Maybe the Bear Stearns brand will live on in some way (shades of Dillon Read), but it looks like the PB and anything else of value will be integrated with JPM as quickly as possible. And so the same firm which first alerted the public to the financial crisis when two hedge funds failed last summer is now that crisis’ first major casualty (ex hedge funds).

I wouldn’t want to be Joseph Lewis right now… the $1.1 billion he invested in Bear last fall is now worth about 98% less, or just $20 million. Talk about a writedown.

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