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Three Things I Think I Think – Fixing Stuff Edition

The weekend is right around the corner. I’ll be in Las Vegas with a group of crazy overworked men from New York most likely riding bikes and reading poetry. I don’t particularly like poetry (or rather, I’m no good at it) so my odds of survival are relatively low. If this is our last interaction I don’t doubt that you’ll find it disappointing.  

1 – Fix the Financial Advisers!  Here’s a nice piece from Jason Zweig about the state of the financial advisory space. Jason notes that it’s harder in most states to become a hairdresser than it is to become a financial adviser. The honest answer to why this might be is that a lot of financial advisory is very basic stuff. I’ve previously laid out the “only basic financial advice you’ll ever need“.  It’s not rocket science. Invest in yourself. Save a lot of money. Buy low fee diversified index funds when you allocate your savings. Contribute to retirement plans. Don’t go to Las Vegas on the weekends, etc. The details are somewhat more complex, but giving basic financial advice isn’t like performing a heart surgery or understanding Tort Law. Heck, cutting someone’s hair might literally be more complex than the advice that 90% of advisers are providing.

That said, I wouldn’t be against a higher hurdle for becoming an adviser. An undergraduate degree in finance or some equivalent prerequisite would be a good start. Advisers deal in an opaque industry that isn’t well understood. Even though much of it is very basic it can still be extremely confusing for the average person. A higher hurdle for providing financial advice wouldn’t be a bad thing.

2 – Fix the Factors!  Here’s a fantastic piece by Patrick O’Shaughnessy on factor investing. He says:

To achieve what we call factor alpha, we believe that investors should use multiple, unique factors to build a more concentrated portfolio of stocks (as few as 50) with the best possible factor profiles. That means not owning wide swaths of the market.

I’ve been pretty hard on factor investing over the years.¹ I basically think that factor investing is the new form of high(er) fee active management in a world where index funds are the most prominent products. In other words, we no longer try to pick the individual stocks that “beat the market”. We’ve now identified certain “factors” that explain excess return anomalies and try to package new index funds by collecting the assets that we believe will achieve that “factor” in the future. I don’t think that’s any easier than picking the best stocks in the market so I don’t understand the point. It looks to me like a new form of high(er) fee active management selling you the dream of “market beating” returns in exchange for higher fees and taxes.

Then again, Countercyclical Indexing is its own kind of factor investing in that I am using very low fee market cap weighted index funds and tilting their allocations across the market cycle based on current relative asset weightings. In other words, I’d argue that future returns come largely from the current state of the capital structure. When equity is in high demand firms will finance their operations by increasingly issuing shares of ownership which will lead to a boom in the relative size of equity financing vs debt financing. The result is an expanding portion of exposure to stocks in the aggregate which makes balance sheets more fragile since equity is a less secure form of financing than debt. The boom precedes the bust and so it makes good sense to counteract this cyclical capital structure trend.

I guess you could call this the “Capital Structure Factor” or something like that. But I’d argue that using that factor to generate “alpha” misses the whole point….I’m not trying to explain where alpha comes from. I am just trying to understand why financial markets boom and bust so we can build portfolios that establish a better balance of risk inside of them. Said differently, the risk factor explains why stocks beat bonds and the Capital Structure Factor explains why stocks become excessively risky at times during the market cycle. I don’t think we have to get much more complex than that, but what do I know?

3 – Fix the Debt!  Here’s a CNN article describing how Bernie Sanders says General Electric is destroying the moral fabric of America. That strikes me as a bit of hyperbole. I happen to think my GE refrigerator has a good moral compass and would never do harm to anyone. But let’s not get bogged down in the morality of my refrigerator. What was really interesting to me was the association of GE’s CEO with the “Fix The Debt” movement. This is a movement which says that the US debt is a grave danger to the future well-being of the United States. Specifically, they state that the “solvency” of the USA is at risk.

Okay, I have to whip out my economist hat here and slap some wrists. What do we mean by “solvency” here? Because, if we mean that an entity with a printing press and its own central bank might “run out of money” then we’ve misunderstood some basic facts. The US government will literally never “run out of money”. So, when we talk about the solvency problem we really need to think about how the US government might create so much debt that it causes inflation. That’s how a sovereign government goes “bankrupt”. And that’s a legitimate concern. But I have to admit that I am worried when I see so many prominent names on the committee of a movement that appears to be based in fundamentally incorrect thinking.

The intricacies of the US government’s state of solvency are a bit complex as I’ve explained here. And I’d probably have to agree with Bernie here that, when you misunderstand these ideas, you’re more inclined to believe things that are not just fundamentally wrong, but perhaps even morally wrong because they will lead to policies that hurt people in an effort to thwart a threat that isn’t actually a threat.

¹ – Sorry to all my good friends in finance who hate me for constantly bashing factor investing which is the hot new toy in portfolio strategy.