Felix Salmon

“I will only say one more thing here tonight, and it’s about the subject that’s close to most of us – and that is remuneration. We have to realize that remuneration has to be something that we earn. It can’t be guaranteed. I see so much so often in recent weeks of those dreaded two-year, three-year guarantees coming back into the market. And if there’s one thing I could ask all of us tonight, it’s to reflect before we sign the next guaranteed bonus for our colleagues across the industry. Because the reality is that we are destroying ourselves when we do it. We need to reward people with objectives that are clear, that are long-term, and that are given to people who are committed to our industry.”

–Michael Geoghegan, CEO of HSBC, addressing a room full of international bankers in London. Take that, Carney.

I was high when I gave my presentation on risk to the Zermatt symposium this morning — 8,471 feet above sea level, to be precise, in an idyllic place called Riffelberg. Who needs wifi when you have views like that. In any event, it went quite well: after all the high empirical seriousness of the past couple of days, I think that the attendees enjoyed me blowing off steam by telling them that we had to do something which of course we won’t do at all: abolish the tax-deductibility of interest, move in general from a world of debt finance to a world of equity finance, and, insofar as there is credit in the world, encourage that credit to be in the form of loans rather than bonds.

“I wondered where you were going there,” said Princeton’s Harold James after I was done, adding that he thought for a while that I was going to propose moving, essentially, to a world of Islamic finance. Doesn’t Islam essentially prescribe from a religious perspective exactly what I was prescribing from a practical perspective?

Yes, it does. One of the themes of my talk was that it wasn’t an excess of greed and speculation which led to the financial crisis, but rather an excess of overcaution, with an attendant surge in demand for triple-A-rated bonds. Investors didn’t want risk, and investment banks made billions of dollars, during the boom, by waving their magic securitization wands and seemingly making that risk disappear. In Islam, high religious authorities are tasked with looking at complex structures designed to circumvent the prohibition on paying interest; in western finance, the ratings agencies played a similar role, blessing highly complex structures (CPDOs, anyone?) which otherwise investors would never have touched.

There followed lunch, and a spectacular walk even higher, to the Gornergrat (10,210 feet) before we descended back to Zermatt on the famous railway to hear Professor James give his presentation, which was very good. James quoted Mervyn King, the governor of the Bank of England, as saying that “the behemoths of global finance have been global in life, but national in death”, and said this posed a problem for small, open countries, including Switzerland, which in general did well during the boom. Such countries just aren’t big enough, he said, to cope with a domestic banking crisis and embark upon a major Keynsian counter-cyclical spending spree at the same time, especially when such spending has to be financed abroad.

More generally, James sees big banks splitting up, becoming increasingly regional and/or national, and the sheer number of banks falling substantially, not least in the US, which has a huge assortment of small banks. The happy medium, he said, is somewhere like Canada, which has a manageable number of large, boring banks which in general don’t venture too far abroad. That sounds right to me, and I suspect that the upshot might be felt very keenly in Mexico, nearly all of whose banks are foreign-owned. Given (a) that the Spanish government has neither the inclination nor the ability to conduct a bank rescue in Mexico; (b) that there are questions over the health of BBVA, the owner of the largest bank in Mexico; and (c) that bank failures are managed by the regulators in the parent country, I can see moves afoot to pressure BBVA into selling Bancomer. The story could be repeated in Brazil and Chile for Santander.

James also raised an intriguing hypothetical, a propos the new nationalism which he sees emerging in the banking industry — how might the world look instead had Dick Fuld sold Lehman Brothers to the Koreans? It’s fascinating to wonder whether that one failed deal might have made an absolutely enormous difference in the future of global banking, between continued globalization and the beginning of deglobalization, if that is indeed what we’re now embarking on.

Why is online advertising so cheap compared to the cost of reaching 1,000 people in any other medium? Anybody whose answer involves oversupply or excess inventory should read Jim Spanfeller:

The only medium in recent history that has had true advertising scarcity is network television, and, with this year’s upfront, one might suggest that even this is no longer true. In every other case there has been either unlimited inventory available (magazines and newspapers) or limits that have rarely, if ever, been reached (radio, cable and spot TV).

Jim’s right that web publishers, in selling off “remnant” inventory at hugely discounted rates, are shooting themselves in the foot. All they’re doing is making it easy for media buyers to get bargains, and devaluing the very idea of online advertising. Indeed, in another sharp insight, he writes:

Some buyers will point to activation levels (clicks, signups or outright sales) as indicators of the relative worth of specific inventory. This is completely understandable as a guideline. But giving it too much weight is problematic. For example, we now know that 16% of web users generate 80% of clicks and that this 16% represents the lower income and education segments of the total user base. Do we really want to be held accountable as an industry by metrics generated by the lowest common denominator and a minority of users to boot? I can’t think of too many successful models using these types of metrics.

These metrics drive the conversation and the core objectives of online advertising away from demand creation (which is basically the definition of advertising) to demand fulfillment or, put another way, direct response. There is nothing wrong with direct response; every other medium has it, and the industry drives huge value for both marketers and media. But direct response is not advertising—it is something different.

In other words, if you’re looking at your clickthrough rate, you’re not participating in the web equivalent of an advertisement, you’re participating in the web equivalent of junk mail. If publishers don’t want to be in the junk-mail business, they should be very wary about going down the clickthrough path.

The irony of Spanfeller’s column is that he’s the outgoing president and CEO of Forbes.com, which was one of the first journalistic websites to aggressively maximize its pageviews at the expense of the user experience. Auto-refresh, slideshows, cutting stories up into multiple pages — all of these tricks make reading content online that much less pleasant, and thereby cheapen the value provided to advertisers. There’s a reason that Vogue doesn’t put ads in the middle of its fashion stories — it’s presenting the best possible editorial product it can to the reader, and advertisers are happy to pay a premium for that. Online, there are very few equivalents, because of the tyranny of the CPM.

I’d love to see a world where the price of online advertising was a function how many unique visitors saw that ad unit, rather than how many times it was served. That’s much more how the print world works. Instead, we’re stuck in a junk-mail paradigm which benefits no one.

In the US, I’m still holding out hope that university endowments will be taxed unless they can demonstrate that they’re actually spending their money on the public good. Thanks to the philanthrocapitalism blog, I now discover that a similar move is now afoot in England, which has told two independent schools that they will lose their charitable status unless they start educating poorer kids as well as those of the rich. The whines from the head of the Independent Schools Council are not very moving:

Private schools were already providing a public benefit by educating children who would otherwise be in state schools paid for by taxpayers, he said…

Without private schools “the public would have to pay between £3bn and £4bn a year in extra taxes,” Lyscom said.

No one’s asking to abolish private schools, or even proposing that most of them lose their charitable status. They’re just asking that they do a bit more to earn it, which seems right to me. But as ever, there’s an endowment effect: it’s orders of magnitude harder to strip charitable status from an institution than it is to confer that status in the first place. So this is going to be a long, tough fight. But it’s one worth having.

Baruch at Ultimi Barbarorum has uncovered this astonishing old ad for the now-highly-defunct Kaupthing bank:

Baruch has all the smart questions. I’ll just ask the stupid one: Did Kaupthing really pay for rights not only to U2′s Where the Streets Have No Name and lots of news-footage B-roll, but also to film clips from Lawrence of Arabia, The Matrix, The Incredibles, The Beach, and the music video for Fatboy Slim’s Weapon of Choice? (And does this mean that Peter O’Toole shares a first-degree connection with Leonardo di Caprio for the purposes of Six Degrees of Kevin Bacon?)

Warner Chilcott is paying $3.1 billion to buy the drugs business of Procter & Gamble. How much of that is its own money, and how much is debt? In the wake of the blowup of so many leveraged loans, one might expect the proportion of the sale price funded by banks to be low. After all, the banks don’t seem to be very keen to lend to anybody these days. But in fact, the banks are providing not half, not 75%, not even 95% of the total — they’re putting up a whopping 129% of the acquisition price.

Yep, Warner Chilcott not only has to put no money down to buy this asset, it also gets an extra $900 million to refinance existing debt. And there’s quite a lot of that, as you might expect from the fact that Warner Chilcott is owned by a who’s-who of the private-equity world, including Bain Capital and Thomas H Lee Partners.

This is being spun as good news. Marketplace’s Jeff Tyler interviewed Ken MacFadyen, the editor of Mergers & Acquisitions Journal:

MacFadyen sees the deal as a heartening harbinger for the banking industry.

MacFadyen: That’s a good sign to see that the lenders are active again.

Me, I’m not so heartened. I’d much rather see the banks’ money going into the real economy, where it can do some good, rather than being used to further lever up a company which was invented by private equity types and domiciled in the tax haven of Ireland.

The leads on this deal are JP Morgan Chase, Bank of America, Credit Suisse, Citigroup, Barclays, and Morgan Stanley. Remember those names, especially if and when any of them starts complaining about how little money they have to lend. Evidently they have no shortage of money if the borrower is one of their old friends in private equity.

Update: Angus Robertson has an excerpt from a Fitch report, under the headline “Investors Swarming Back Into Leveraged Finance Markets”. ‘Nuff said.

Neil Unmack is constructive about Spain in general, and Spanish banks in particular: Santander knows its own loan book better than anyone, he says, and if it’s happy to buy back billions of euros of its own bonds at 82% of par, it probably knows something the market doesn’t.

On the other hand the notorious Variant Perception report on Spain and its banks, quoting Edward Hugh at some length, makes for very sobering reading. Read at in the light of the report, Santander’s buy-back begins to look more like an act of desperation than one of strength — and one which bondholders would do well to tender into.

It’s undeniable that the implosion of Spain’s formerly-hot construction sector is going to blow holes in a lot of balance sheets; the only question is where and when. The gist of the Variant Perception report is simple: the problems of Spain’s construction industry and homeowners have become the problem’s of Spain’s lenders, and the problems of Spain’s lenders are going to a major problem for all of Europe, going forwards. Meanwhile, Spain will become Ireland-but-worse, as real interest rates soar thanks to deflation and extreme levels unemployment, combined with low wages, depress the entire economy for the foreseeable future.

That said, it’s important to draw a distinction between Spanish banks in Spain, which are largely domestic savings banks, and Spanish banks as they exist in the imagination of the international capital markets (Santander and BBVA). Santander is a well-managed and internationally-diversified bank, which does retail banking extremely well. BBVA owns the largest bank in Mexico, Bancomer, and has built an extremely strong franchise stretching from Texas, through Mexico and central America, and down through the Andes. While neither bank will be immune to a national disaster in its country of origin, their international holdings will help to soften the blow.

At heart, however, the situation in Spain will be familiar to many US observers: consumers augmented their low wages by making huge amounts of money in a soaring property market. And now that the property market has stopped soaring, they’re left with hundreds of billions of euros in loans, an enormous percentage of which will end up in default. The problem in Spain is exacerbated by the fact that much of the property bubble was concentrated in the beach-home market on the coast, where the willingness of homeowners to pay mortgages on underwater properties is much lower than historical data would suggest.

The problems in Spain have taken longer to emerge than those in the US or Ireland for two reasons. Firstly, Spanish lending standards were generally tighter than in Anglophone countries, giving banks more of a cushion to absorb losses or refinance souring loans. And secondly, the massive influx of liquidity which hit the world in 2008 as a response to the global economic crisis is helping to hide the scale of the problem in Spain: it’s worth noting that Santander is tendering for more than $23 billion in mortgage-backed bonds “through its normal liquidity facilities”. But neither of these two factors is sufficient to withstand an economic crisis of the one facing Spain. My feeling is that the pessimists (and the other Neil) are right — the situation in the country is going to get much worse, and spill over into the rest of Europe, long before it gets better. We haven’t hit bottom yet.

Kevin Drum and Ryan Avent bring up the question of optimal regulatory structure, and I agree with both of them.

Kevin is right that the Federal Reserve — which is owned by big banks and whose regulatory function exists to keep them strong — is not naturally inclined to protect consumers: after all, banks which treat consumers badly are often that much more profitable. The Fed, writes Kevin, is

institutionally and culturally oriented toward the financial community and macroeconomic management. Consumer regulation will never be taken seriously there no matter how many laws we write.

Well, “never” is a long time. But I think he’s right, practically speaking: if a Consumer Financial Protection Agency were to be created under the auspices of the Fed, then its officers would be taken less seriously than the prudential regulators overseeing systemic risk.

That said, however, a lot of the time all of those officers would be pulling in the same direction. Subprime mortgages are only the most obvious example: what’s bad for consumers can be systemically dangerous, too. And there would be advantages, as well as disadvantages, to a CFPA being part of the Fed: once senior Fed officials were convinced that the CFPA had legitimate concerns about a certain institution, there would be no question that the bank in question would reform its activities sharpish.

Which brings us to Avent, who has “a tough time seeing how a more fractious regulatory environment is a better one”. There are very good reasons why a single regulator is much better than an alphabet soup, where senior management at the various different agencies spend more time fighting with each other for power and influence than they do actually regulating. Ryan misunderstands my earlier blog entry: I don’t for a minute think that regulatory authority should be distributed. To the contrary, I think that it should be consolidated: the CFTC should merge with the SEC, the combined agency should become part of the Fed, and eventually, as the Tories are suggesting in the UK, the central bank should regulate everything.

Is such a thing realistic, or would the resulting behemoth be too big to manage, a bit like Citigroup? I think the answer would be to make the different arms of the super-regulator largely autonomous, but to encourage employees to move from one part of the institution to another quite regularly. Infighting within an institution is generally easier to manage and minimize than fighting between institutions.

It’s a sign of the severity of the financial crisis that Barack Obama is re-nominating Ben Bernanke as Fed chief now, in August, despite the fact that his term doesn’t end for another five months. It’s one of the few sources of potential uncertainty which the White House can address and resolve unambiguously, and it’s good that it’s happening.

Obama is following Bill Clinton’s lead in reappointing a Republican Fed chairman who was appointed initially by a Republican president. In fact, by the time Bernanke’s second term expires, it will have been 28 years since a Democrat, Paul Volcker, held the post. But the good news is that Bernanke isn’t party-political: it’s pretty unthinkable that he would ever pull a stunt like Greenspan testifying before Congress in favor of tax cuts, on the grounds that things get a bit complicated when the government reaches zero debt. (Ha!)

It’s also good news, in its own way, that Bernanke has some opposition in Congress: it’s right and normal that the Fed chief should upset lawmakers. But now that he’s been renominated (and his confirmation is a slam-dunk), maybe those noises about the central bank losing its independence might die down a little.

Krugman’s latest graph of U.S income inequality is fairly eye-popping

Noether’s theorem says a conservation law is a consequence of invariance, but in Santa Fe it’s the other way around

A $3 wine at Safeway: “how can it be any good?” A $3 wine at Trader Joe’s: “how bad can it be?”

The KFC Doubledown? Yes, it’s real. And 1,228 calories.

Does having an MBA or CFA lead to superior portfolio performance? CFA – yes, MBA – no

Larry Lessig’s blog is retired.

The implosion in the enterprise value of Reader’s Digest is astonishing — from $3.8 billion two years ago to somewhat less than $1 billion now, depending on how much the equity of the new company will be valued at when it emerges from bankruptcy, and assuming, generously, that the new debt is valued at par. Chelsea Emery talked to lawyer Richard Mikels:

“One way to deleverage is by turning debt into equity. That will happen more and more throughout the economy over the next several years,” said Mikels.

That’s true. On the other hand, when private-equity shop Ripplewood bought the magazine company for $1.6 billion in 2007, layering on $2.2 billion in debt, the simple debt-to-equity ratio was 1.375 — not enormous. The new Reader’s Digest will have $550 million in debt, which means that if the equity is worth less than $400 million, it will actually be more levered than the old, height-of-the-credit-bubble deal.

So what is the enterprise value of Reader’s Digest? In the 12 months to March 31, it had Ebitda of $280 million, which sounds impressive until you notice that the number is made up of a $995 million net loss, plus $1.24 billion in “adjustments”. In other words, it’s useless. If you look at the slideshow for the most recent quarter, you’ll see some more useful numbers. Revenues were $479 million — down 17% year-on-year. “Product, Distribution & Editorial Expenses” were $207 million, down 15%; “Promotion, Marketing & Administrative Expenses” were $270 million, down 19%; and the operating loss for the quarter was stable at $7 million.

In other words, Reader’s Digest isn’t making money even with zero debt, let alone $550 million, and it wasn’t making any money a year ago, either. How much money would you pay for the privilege of losing $7 million a quarter before interest payments?

It’ll be interesting to see where the market values that $550 million in new debt: I suspect it’ll be somewhere less than par, depending on what kind of coupon it carries. And I suspect too that the value of the equity will be rather less than $400 million. Nothing’s really changing at this company: there’s no talk of layoffs, or closing unprofitable properties, or anything like that. The owners have an interest in keeping the company big, because that’s the only way it’ll ever be able to pay off $550 million in debt. Essentially, they’re keeping the company’s embedded leverage, and buying themselves an option: if the advertising market takes off, then the new, leaner Reader’s Digest could become very profitable very quickly.

But that’s not the base-case scenario: print media is hardly a growth industry these days. So don’t be too surprised if this isn’t the last we hear about this particular company’s troubles.

I’m in Zermatt, Switzerland, where I’ve been invited to attend a symposium on the second anniversary of the financial crisis. I’ve only been to one presentation so far, but I’ve already learned two things: (a) that a lot of private bankers in Switzerland have degrees from the country’s famed hospitality universities (service culture is service culture, I guess), and (b) I can actually comprehend the gist of a speech given in German, if the slides are in English, and the points made are conventional enough.

On the way up here I worked my way through the latest edition of The Atlantic, which has an 11,000-word essay by David Goldhill on the US healthcare system, and 7,000 words by William Cohan on the acquisition of Merrill Lynch by Bank of America. Goldhill’s piece is spot-on in terms of diagnosing the problem, and his proposed solution, if implemented ex nihilo, sounds pretty good. Unfortunately, he gives no reason to believe that we can get there from here: healthcare is path-dependent, and we’re far too far down one path to be able to switch over onto a completely different one.

As for Cohan, I’m very unimpressed by the way in which he strongly implies that the government was going around abrogating contracts when it bullied Ken Lewis into acquiring Merrill Lynch. The fact is that Bank of America had signed a contract saying that it would buy Merrill; if anything, it was Ken Lewis, with one eye on the infamous MAC clause, who was looking desperately for a way to get out of that contractual obligation. And Cohan’s reading of the Detroit bailouts is contentious indeed: he says for instance that Chrysler’s senior creditors “were contractually entitled to a much better deal” than the one they got. Which simply isn’t true: when it comes to bankruptcy, the party providing the financing (in this case, the government) calls substantially all of the shots, and in any case the bankruptcy judge has a large amount of judgment in terms of who gets what.

Cohan concludes by raising

the possibility that Treasury and the Fed will continue to simply manage the financial industry informally for some years to come, confident in their ability to pull the right levers and twist arms when necessary behind the scenes. That’s a scenario that seldom ends well; we should hope it doesn’t come to pass.

I’m on the other side of this argument. Banks, left to their own devices, brought the entire national economy to the precipice of disaster. They had their chance to operate outside the realm of political interference, and they flubbed it, massively. Now that Treasury and the Fed are keeping a closer eye on things, there might be less opportunity for bankers to make enormous profits by risking the whole system. If there is, that’s a good thing.

The first thing that regulators do isn’t regulate: the first thing that regulators do is try to maximize their own power. Then, and only then, do they even think about using that power. Item:

The Securities and Exchange Commission says it is taking a close look at flash quotes, high-frequency trading and other dark corners of the stock markets.

But by many accounts, the agency is outmatched by the traders and market venues with technology that is remaking the trading world.

The agency lacks its own traders with knowledge about cutting-edge strategies and how the markets operate. It long ago ceded the daily surveillance of trading to self-regulatory organizations, like NYSE Regulation and the Financial Industry Regulatory Authority. And it takes a lawyerly approach to regulation and rule making that rarely employs deep analyses of real trading data.

The SEC has enough of a mountain to climb just trying to be effective at the stuff it already does: this kind of mission creep helps no one. It makes a certain amount of conceptual sense that the SEC should be regulating trading strategies, but it doesn’t make practical sense — not unless and until the SEC has proven that it’s more competent than this.

In the mean time, who best to keep an eye on high-frequency trading and the suchlike? Well, the CFTC might be one place to start, especially since in an ideal world the SEC and CFTC would be merged into one entity, and also since at least as much high-frequency trading goes on in commodities and derivatives markets as goes on in stock and bond markets. A bit more cooperation between the two would do no one any harm.

I’m not generally a fan of management books, maybe because I’m not a manager. So it’s probably just as well that I didn’t realize that The Flaw of Averages, by Sam Savage, was a management book before I started reading it. The highest praise I can give it is that I finished reading it — all the way through — which is something I don’t think I’ve ever done with a management book. Savage is a clear and gifted writer, which helps, and I’m interested in the subject matter, which also helps.

But there was something else which kept me reading: I was waiting for the other shoe to drop, and it never did. The basic thesis of The Flaw of Averages is not only true but mathematically provable: when you’re dealing with probability distributions rather than certainties, you can find yourself making all manner of horrible and costly errors if you try to boil those probability distributions down to a single number like an average. Instead, contemporary software, much of it based on Savage’s own research and development, allows you to create and manipulate those distributions directly, with much more useful results.

Savage advocates that companies create a new position, the Chief Probability Officer, charged with coordinating the institutional knowledge about probability distributions. He writes, in what might be the nub of the whole book:

Managers at many levels are just bursting with probabilistic knowledge, which if properly channeled can be put to good use.

Of course, the question of how to put the knowledge of lower-level managers to good use is not a question confined to probability distributions: really, it’s the central question of all management theory. But substantially all of this book deals with the question of how best to deal with probability distributions; there’s nothing at all on how to smell them to see if they make any sense, or how to judge how accurate they are.

Most startlingly of all, there’s no discussion of what probability is. One of my favorite parts of Riccardo Rebonato’s magnificent book Plight of the Fortune Tellers is chapter 3, “thinking about probabilities”. He makes the hugely important distinction: on the one hand there’s frequentist probability, where you can run the same experiment thousands of times to see what different results occur. On the other hand there’s subjective probability: if I ask what the probability is that oil will hit $100 per barrel in the next five years, you can’t do that.

Many people, Savage included, love to run Monte Carlo simulations in order to try to reduce subjective probability to frequentist probability, but there’s a category error going on whenever that happens, which is one reason that financial instruments designed by running Monte Carlo simulations blew up so spectacularly during this financial crisis. Monte Carlo simulations are very bad at showing the risk of something unprecedented happening, but as Nassim Taleb loves to point out, it’s the unprecedented events — the black swans — which tend to be crucially important.

On page 291 of his book, Savage prints an admittedly hypothetical distribution of future sea levels. He then goes on to explain why the distribution is oversimplified, and why we can’t trust it in its initial oversimplified form. But the fact is that his base-case scenario, the place where he starts his analysis, is a thin-tailed normal distribution, with the chance of sea levels rising in future being exactly the same as the chance that they will fall.

I just can’t believe that that kind of normal distribution is ever a useful place to start when thinking about something like climate change — the subject of the chapter at hand. The chances of sea levels falling from their current level are tiny — much lower than 50%. And the histogram going out is very bumpy indeed: to a first approximation, either Greenland and the west Antarctic ice sheet melt into the sea, or they don’t. Tails don’t get much fatter than this one.

But this whole book reads as though it was written in what Taleb calls “mediocristan” as opposed to the real world of “extremistan”. Tails are thin; Black and Scholes and Merton and Markowitz are heroes; probability distributions can be modeled and tamed and understood on a seat-of-the-pants level.

It’s true that the world of The Flaw of Averages is better than the world we’re just emerging from, where things like value-at-risk and correlation were disastrously boiled down to single numbers. But I’m still not sure I want to live in Savage’s world: it seems to me to be lacking a healthy dose of fear of the unknown. Quite the opposite, in fact: large chunks of the book are devoted to the riches that can be struck by identifying “real options” and buying them on the cheap from people who, looking only at averages, might overlook a lot of option value.

My fear is that if Savage’s souped-up Excel spreadsheets catch on, the corporate world will fall into the overconfidence trap which did for the financial world during the Great Moderation. Savage’s statistical distributions are extremely powerful tools, both in terms of identifying profitable opportunities and in terms of avoiding massive potential downside. But if companies become particularly adept at avoiding crashes, then that’s a recipe for yet another Minsky bubble. The fewer corporate disasters we see, the more risk and leverage that companies will feel comfortable taking on, and the more likely it is that another system-wide crash will occur.

Savage’s techniques are very good at discovering existing correlations which might not be immediately visible to senior management. But they’re useless at discovering correlations which were never significant in the past but which suddenly and terrifyingly go to 1 in the future when a Black Swan arrives.

If we all take Savage’s advice, we’ll weather most storms much better than we do right now. But I fear we’ll fare even worse in the event that a hurricane hits.

Update: Savage responds:

I believe in Black Swan thinking whole heartedly, but have been amazed to discover that most of my students (both university and executive) don’t even grasp the concept of a distribution in the first place. I also agree that any technology can lull people into a sense of security, but distributions of any kind are not as bad in this regard as single numbers. And my hope is that shaking the ladder in any manner will encourage people to stop fixating on the right answer, and start thinking about the right question, which is the proper defense against the black swan.

Actually one of my favorite interactive simulation demonstrations is black swanish, and sharply contrasts the Right Answer and Right Question schools. I didn’t think I could do it convincingly in the book because it is like writing about what it feels like to ride a bicycle, but I will try here. It involves picking a portfolio of petroleum prospects (like the Shell model), where one of the projects (site A) is a very attractive natural gas field, but is in a politically unstable part of the world, and there is a chance it could blow up politically.

Right Answer approach for dealing with the board of directors:

Ladies and gentlemen, we need to estimate the probability of an overthrow at our favorite site A, so we can chose an optimal portfolio that protects us in this event.

A committee is formed and after months of discussion it arrives at a 15% probability. Yes, there is a reasonable chance the place will blow up (lets call it a grey swan), but It is ridiculous to think you could estimate the probability with the accuracy implied by “15%” This analysis would rightfully deserve the wrath of Taleb.

“Right Question” approach:

We plug probabilities of overthrow ranging from 0 to 100% into an interactive simulation. As soon as a probability is plugged in, one thousand trials are run for each of 100 potential portfolios, nearly instantaneously. As we do this we observe the shape of the galaxy of portfolios in risk return space being deformed by probabilistic forces. We also notice that for all probabilities ranging between 3% and 97% that a few portfolios stay on the efficient frontier. These portfolios all contain both site A, and a less attractive site B, which is an alternate supply to the same market. Thus if A blows up, the price of gas goes up and B becomes a gold mine. This leads to the right question for the board of directors.

Ladies and gentlemen, do we hedge site A with site B? We are having an up or down vote in five minutes.

Well now you can see why I didn’t write about it, but if you ever have time for a webex, I find the demonstration dramatic, because I had no idea that the hedge of A with B would be optimal for such a huge range of probabilities.

Most investors have a significant exposure to bond funds. But according to S&P’s latest SPIVA report — by far the best comparison of fund performance to underlying indices — nearly all of those bond funds have underperformed their indices:

In case you can’t see this clearly, it says, among other things, that over the five-year period ending June 2009, 92% of investment-grade long funds have underperformed the index, 98% of mortgage-bond funds have underperformed the index, and 94% of general muni funds have underperformed the index. If you bought a California or New York muni fund, you had a 100% chance of underperforming the index.

Sam Mamudi, reporting on these results for the WSJ, puts them in the context of “the debate over passive versus active mutual-fund investing” — but he leaves out a crucial piece of information: passive investing in bonds is non-trivial. If you look at the performance of equity funds against the S&P 500, say, you can do so in the knowledge that it’s pretty trivial to buy an index fund or an ETF which will give you something very, very close to the performance of the index. With these bond indices, however, that’s not the case.

There are some bond ETFs: iShares, for instance, has a pretty broad suite of them. Most of them are pretty young, having been launched in 2007 or later, but there are a couple of older ones, such as the 20+ year Treasury bond fund (TLT). If you look at the information iShares provides, however, it’s really hard to tell how good the fund is at replicating the return of the index. We know that on June 30 its net asset value stood at 94.62, up from 83.41 five years previously; we can also find out that over that time the fund paid out 20.435 in dividends. You don’t want dividends, or you find them expensive to reinvest? Tough luck. We also know that the benchmark index increased from 237.77 to 388.29 over that time.

The index, then, increased over the course of those five years by an annualized 10.3%. If you just add the dividends onto the net asset value for the fund, you get an increase from 83.41 to 115, or 6.6% annualized. That’s pretty much in line with the 6.94% weighted average annualized return for long government bond funds generally.

What happens if you run the same exercise for IVV, iShares’ S&P 500 index fund? The index went from 1661.53 to 1498.94. The fund, meanwhile, went from 113.26 to 92.24 with 12.3185 in dividends. The index’s annualized return was -2%, while adding the dividends to the NAV of the fund gives an annualized return of -1.6%. The index fund outperformed the index, on this methodology, partly because you weren’t reinvesting dividends in a falling asset, but also because dividends are lower on stocks than on bonds, even government bonds.

But all of that is just doodling, really. The important thing to remember when it comes to bond funds is that realistically you should only be comparing managed bond funds to index bond funds, rather than to indices directly. After all, your choice isn’t between investing in a managed bond fund and investing in an index, it’s between investing in a managed bond fund and investing in an index bond fund. So while it’s true that a startlingly high percentage of managed bond funds underperform their index, it’s not necessarily true that the same percentage of those funds underperforms an index fund linked to the same benchmark.

Update: Wcw, in the comments, points me to this document, in which iShares says that the five-year return to end-June 2009 of the TLT fund was 7.25%, while the index return was 7.32%. The return on IVV was -2.28%, while the return on the S&P 500 was -2.24%. Even the TIPS bond fund, which Pimco disparages so, returned 4.80% to the index’s 4.94%. I would assume, of course, that these returns assume no commissions or bid-offer spreads when buying or selling the funds, or reinvesting dividends.