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By Kiran, April 21, 2010 6:25 am

A few years ago I wanted to be a day trader, a pirate on the high seas, a Gordon Gekko-lite that raided the holds of the slow moving freighters. So I bought subscriptions, I bought software, I bought accounts, I believed it was the beginning of the end of he slavery, the beginning of the glory. It was so easy to see myself making all the right investments, picking the exact winners among the gazillions of losers, timing the trades to the perfect picoseconds, that I somehow forgot that I am after all one single speck of dust in an beach full of pebbles.

And all this was after a pretty grounding talk by a professor at school who had studied individual traders over years in Taiwan and in the end concluded that individuals lose an average of 5% over their trading lifetime (found the paper, here it is). If that were true, shouldn’t the losses of most day traders be a deterrent to new entrants? Yet, there are still hoards of new traders who are getting into the market thinking that they have that extra sauce that nobody else inherited. In reality, I believe that this attitude is no different than that of gamblers who are clearly aware of the advantage the house always has, and yet are so immensely confident in their skill that they are willing to let their emotion blind the simple truth and risk it all anyway.

Lets not get caught up in metaphors, lets see the underlying economics. Day traders are betting on short-term volatility, that they are going to be on the right side when the prices move. However, there is a problem with short-term bets – first, short term movements are not based on infinitesimally small chunks of new information that can be exploited, instead they are based on the collective impact of the thousands of trading actions undertaken by the hundreds of thousands of larger market players, and subsequently, short term trend based trading is on an average random at best. Second, if there were delays in the assimilation of new information into the price of a financial instrument, there is absolutely no way on earth, an individual investor will be the one making that correction. Simply, there are too many more resourceful human and machine participants with near-infinite computational and analytical resources that are trading on not just every iota of new information but also based on every possible correlation that new information might have with any pre-existing knowledge.

Finally, the question that I really asked myself was, what is the economic value of a day trader? I understand the economic value of financial institutions, that is to help in the efficient allocation of capital among the deserving firms in the market. But what of the individuals, are their day to day trading activities helping in this efficient allocation process? Maybe. One one hand, there is a possibility that individual traders as a group are simply fine tuning this allocation process that is largely done by the larger institutions. But on the other hand, there is a fairly strong academic opinion that day traders, because of their non-collective decision making are simply creating random noise as a whole that simply does not add any economic value to the market. I know for a fact that there are several stars in the day trading world, the ones that made millions out of nothing, and somehow end up selling their so-called secrets in deceptively overpriced seminars and tapes that are advertised in the wee hours of the night. They are there, and the worst part is that they make a difference, just like there are those few that strike the progressive jackpots in Reno and raise the hopes of everyone around them. And while I have nothing against people who make a living in this profession, it is only my personal perspective that individuals involved in short-term trading are no different than professional gamblers, who are trying to get a small cut from an extremely profitable industry. However, I do believe that long and medium term investment based on fundamental analysis, even by individuals, does create economic value and actually influences market prices.

At the end of the day, I like to remind myself that there is no free ride, there is no sense of satisfaction to be had in a profession that is driven solely by personal greed, and a job that possibly adds zero economic value to society. Philosophy aside, why would I waste my money betting in a random and fickle market, where my overall chances of making money are less than 1%, when the odds of winning by playing black or red in roulette is a solid 48.5%.

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By Kiran, March 16, 2009 6:05 pm

What a blast from the past. FASB is finally issuing new guidance about market-to-market accounting rules after much finger pointing from both the Congress and the Wall St wonks. Almost a year ago, there was a big furor by Blackstone’s Schwartzman about the potential dangers of FAS 157 and the blogosphere debated about it pretty extensively. A recap – FAS 157 forces companies to value their assets to the price the market is willing to pay and not the actual cash flows that are generated by the asset. So if you hold a complex derivative product which has a intrinsic value of $100, but the market is willing to pay only $10, you take a $90 loss. So a mortgage backed security which is not subprime could be sound fundamentally but because the market is wary of these securities, you have to mark them down on your balance sheet. I did a presentation last year (link below) on how companies could benefit themselves by using a loophole in market-to-market valuation. I don’t pretend to be an oracle on financial matters, but I do remember sending a pretty clear message to my class that fair-value will burn most balance sheets as the market cools down.

While most of the financial industry is mad at FASB for FAS 157, do remember that it is not mandatory. What everyone forgets is that back in the heyday when all was good and valuations were sky high, most of the firms chose mark-to-market because they could mark up their assets and create income from thin air. When the market is suddenly illiquid, the same hawks are trying to blame the accounting rule. When securities are based on complex models and are comprised of diverse securities, it is almost impossible to factor all the risks comprehensively; yes, they can calculate alphas, betas, gammas and thetas, but how do you model the risk of illiquidity. These securities should never have been classified as mark-to-market in the first place. At this time, because of the immense illiquidity in the market, a relaxation of the 157 might be justified, but I am wary as to whether this will set a precedent for further opacity in asset valuations. Unfortunately there is no middle ground and FASB should not be the one to blame; the rule as it is, is more than fair even if not precise in its guidance.

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By Kiran, March 2, 2009 7:21 pm

Today AIG sounded more like ‘Americans in Grief’ than ‘America’s International Grandiose’. Both WSJ and NYT had front page articles covering the big bad wolf and how it was consuming our hard-earned dollars faster than we can say kaboom. There is a large public debate on whether nationalization of banks and financial institutions is a smart idea or not, and for a change the public debate is actually not divided on party lines. As I write this entry, “we the people” already hold a 80% stake in AIG, and the Obama administration is continuing to be the faitful medic attending to the dying corpse. Nationalization, to me, is almost anti-capitalism and anti-free-market principals; but like countless others I have recently come to realize that free markets only work when they can self-regulate effectively, which is somewhat irnonical given that they only exist because of individuals’ greed.

Nationalization, at this stage, is almost necessitated in order to prevent further collapse of the financial institutions. AIG for one, is the largest insurer of other corporations’ balance sheet assets, and has been scraping together margin as those same assets decline some more every day. The other problem is the increasing premium on the scores of Credit Default Swaps that suddenly defy all traditional default-risk models. There was a excellent series or articles on WaPo a few weeks back (part 1, part 2) that I had to go and re-read to understand how we even got here.

Pondering about the question on nationalization, I had to but think back to India and how Indira Gandhi’s goverment comsumed all 14 of India’s largest banks in one fell swoop in 1969.  In a second act, the government nationalized the six next largest banks back in 1980. Today, out of the 88 commercial banks in India, 27 (the largest, including State Bank) note the Indian Government as the largest shareholder. To put in perspective, 75% of the country’s banking assets are in the hands of our trusted government. Do remember that India was and is still fairly socialist in terms of economic policies, and Indira Gandhi epitomized populism in her era by her aggressive expansion of the Government’s power. Looking back, there are several incentives of having a nationalized banking structure, and that is despite all the red tape and beareucracy that such a system would entail.

Nationalization for the most part eliminates the profit targeting and risky investmenting that most bankers embark on, making banking more accessible to more people, and regulatory oversight more achievable. Also to note is that the Reserve Bank of India, the counterpart of the US Fed is completely nationalized, unlike the Fed which is a quasi-autonomous entity with sometimes squemish objectives. Nouriel Roubini, a well-respected economist from my alma mater, NYU, has been pushing the nationalization idea for several weeks now and has become a staple of the news networks’ analysis. Roubini proposes that the government nationalize all the banks that are deemed insolved as per the Treasury’s ‘stress-test‘, and quickly separate the acquired assets into good and bad for easy disposal. Per Roubini, “Basically, we’re all Swedes now. We have used all our bullets, and the boogeyman is still coming. Let’s pull out the bazooka and be done with it.”

Like Roubini, I believe that the time has come for partial nationalization of the banking sector; the ‘bad bank’ scenario that has been doing its rounds for the last few weeks actually seems like a good deal at this time. The Fed and Treasury simply can’t make enough impact on the flow of credit in the markets the same way a nationalized bank can. Instead of continually bailing out financial institutions that are sinking money into their extremely diversified operations, the government should rather nationalize the depository units of the insolvent banks and auction off the remaining units. More than these measures, I believe it is time to reinstate the Glass-Steagall act, which although might force major restructuring in financial institutions, will provide the necessary confidence to the market (More on this later). The nationalization on Indian banks was not that bad an idea, even though they fluttered and faltered and are somewhat inept, they do serve as a major backbone and allow the government to control credit. The Indian banking industry does not need the same kind of life-support as American banks for that very reason. Depository institutions are the life-blood of a nation’s trade and well-being, and cannot be allowed to play roulette with the citizens money.

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By Kiran, February 19, 2009 8:26 pm

Today I had a chance to skim through the restructuring plans presented by GM and Chrysler to Congress (GM Plan, Chrysler Plan). GM’s situation is much alike Citi’s; both are too big to fail, both have a lot of toxic assets on their books, and both have a far reaching ripple effect on the global economy. What is different is how Obama is dealing with each situation; while the government is TARPing Citi’s assets, it is giving free cash to GM and Chrysler despite the expectation of an at-best diminutive return on its investment. I think a more simplistic and radical approach is the only way to save the GM goliath from falling off the cliff.

1. Fire the UAW - Over the years the UAW has outgrown its real purpose and has graduated into more of  a political party than a workers advocacy group. If Toyota, Honda, and even Walmart can successfully run their large organizations without a union, why cant the automakers? In 1981, when 13000 of the 17000 air traffic controllers striked, then President Reagan sternly said the striking employees would simply be terminated if they did not return to their jobs within 48 hours. The public sided with the government, and most of the air traffic controllers promptly returned to their jobs, except a few that kept standing in the picket lines. So I say, fire the UAW, its about time; I can guarantee that 90% of those employees will return as non-union employees given the economic situation. Nobel laureate Fredrick Hayek rightly said, “We have now reached a state where unions have become uniquely privileged institutions to which the general rules of law do not apply”. While I am not an anti-collectivist per se, I do believe there needs to be a boundary between good faith bargaining and unchecked strangleholding. Union workers across this country take home a 21% premium over their non-union counterparts and the goverment’s steady protectionism  has only bolstered such arrogance. If the United States is the greatest free-market economy in the world, there need to be limits to the powers of workers unions; why should a company that is on the brink of collapse be incessantly begging its union to negotiate pennywise paycuts.

2. Become a three-brand company – Hummer, Saturn, and Buick have far outlived their usefulness; for a company that is trying to stay afloat, this is not the time to attempt a rejuvenation of its niche brands. Toyota though technically has three brands, it is in all reality still a one-brand company. I am fairly confident that most people don’t even remotely associate Toyota with Lexus and Scion. This may be in part due to the company’s smart brand development over the years as well as the fair amount of differentiation within its three brands. On the other hand. Chevy, Buick and Pontiac offer almost no significant brand differentiation and instead cannibalize each others sales. With a portfolio made of Chevy, Cadillac and GMC (for its truck business), GM could actually offer some real differentiation and become more competitive. Most of the new Chevys are somewhat on par with the Japanese offerings, despite being slightly behind on their engineering. A more focussed campaign and an emotionally appealing marketing strategy that plays on people’s patriotism might actually put Chevy in the peer group of Toyota within two years.

3. Bailout the retirees and let the company run its course – Every GM vehicle carries a $2000 retiree tax which clearly becomes evident in the quality of the cars produced. In essence, an Avalon could actually have an extra $2000 worth of goodies in addition to better engineering and still sell for the same price as a full featured Impala. Between GM and Chrysler, the pension and retirement liabilities are a staggering $30 billion and that is not even counting the ridiculous benefits programs like the unemployment-differential coverage, etc that GM offers. I think Congress, in one sweeping populist act, should take these liabilities off the automakers and administer them through a Veterans’ Affairs like agency. Then, GM, Ford and Chrysler would have a level playing field with Toyota and Honda, and can actually prove their competence or lack thereof without the excuse of a “pre-existing condition”. If GM can resurge without being bogged down, then it will regain its prominence within ten years, if not, it should be allowed to go bankrupt. Free enterprise exists because firms are allowed to seal their own fates, if private institutions are allowed to constantly haemorrage and need continuous life support, they are not being true to their shareholders.

Every newspaper in the country has been running front-page stories about the impending collapse of the industry and the two million jobs that could disappear in the aftermath. But then, there is absolutely no way in which a significant turnaround could be achieved without massive layoffs. GM, in its plan to Congress, has stated that it would cut 47,000 people as part of its restructuring if it were to get the additional bailout loan. Chrysler on the other hand, desperately needs the strategic alliance with Fiat in order to refresh its lineup, plus there maybe a few lessons to be learned from Fiat about small cars. In another life, I had once studied a case om how the Nissan-Renault alliance made Nissan profitable within two years and Carlos Ghosn the poster child of the auto industry. While both Nissan and Renault are both reporting losses primarily due to the flogging economy, there were indeed several significant synergies realized in the alliance that helped Nissan streamline its lineup and revive its brandname.

The economic repurcussions of a GM failure could be catastrophic in all reality, and hence it is even more important to ensure its long-term survivability and accept the short-term consequences. Just as we are becoming aware of that baggage fee for every extra bag, GM also needs to start recognizing the price it has been paying for its baggage over the last ten years. Much like a patient that sometimes only wakes up from an electric jolt rather than constant CPR, the automakers need to send a jolt to their troops instead of another memo. If even one of the big three can start breathing again, the other two will follow suit.

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By Kiran, November 4, 2007 11:22 am

I recently had a chance to attend a talk by Dennis Johnson, who is the Director of the Corporate Governance program at Calpers. Some of the points I garnered from his talk…..

Small Portfolio, Big Returns

The CG portfolio in Calpers is only $12B, which is only a twentieth of their total portfolio; despite its small size its performance is 50% better than the entire portfolio. The interesting thing is that only $5B of the fund is actually committed, of that $5B only $1B is invested internally. Now the $1B internal investments have shown almost 26% return in the last few years which is, to my astonishment, terribly high. My view of CG investing was that these are fairly passive and tend to manifest in the form of long term results rather than short-term. The remaining $4B is invested in private CG funds (whose names I dont remember, but one of them is run by a former SEC chairman). The CG group is still trying to commit its full portfolio but has had a hard time trying to come up with suitable vehicles.

Shareholder Proposals and the Focus List

Another misconception I had was that the much hyped focus list published by Calpers each year is based on their entire portfolio, but in reality it is the work of the CG group. Stan’s group, made of just 17 staff members, gleans the under-performers from their overall portfolio, applies a bunch of CG-related checklists and generates a list of 50 or so companies that have poor CG. All of these companies are given advance notice several months before the list is published (the next list is due in March 2008), and are given opportunity to implement a list of changes. While many of these companies succumb to the pressure of being named to the focus list, and subsequently make many of the proposed changes, the remaining ignore the warnings.

Now Calpers is a permanent investor i.e. they don’t pull out of an investment even if it underperforms for a prolonged period, one reason being the huge transaction cost associated with their typically large investments (several 100 millions many times). The only option left on the table for them is “shareholder proposals”…… these can range from access to proxies, to declassifying boards, to changes in executive compensation committees. Calpers proposals have been fairly strong in garnering support and have passed over 60% of the time; typically, they try to convince boards to make the requisite changes before making the proposals themselves. A common misconception is that these shareholder proposals are expensive, but in reality they are not, the bulk of the cost is born in proxy solicitation which is outsourced to specialized firms that do this (this typically costs $20-30K per proposal). Not too expensive considering that a shareholder proposal or being named to the focus list can convert a typical under-performer (-10%) to an out-performer (+2%) within 3-5 years.

Negative cash flows grow each year

Calpers portfolio has grown tremendously over the last 10 year, more than doubling in value to almost $300B. Each year the agency pays about $9.2B towards retired employees pensions and health plans, which is expected to grow significantly as the baby boomers start retiring in droves. On the other hand, Calpers generates over $9B in revenue each year through their investments, the resulting negative cash flow of $200M is covered though various means – dividend collections, divestments, portfolio rebalancing, etc. While I don’t know the projections for the growth of this negative cash flow, I am sure Calpers’s investments are flowing to more liquid high-growth vehicles in the recent years.

Calpers own executive compensation comes to light

Talk about a coincidence, on the same day of the talk, I read a front page article on WSJ about how public pension fund managers are demanding higher pays each year. Russel Read, Calpers CEO, apparently took home close to a million dollars in compensation last year; WSJ didn’t chastise calpers for this, because despite being a public passive fund, the pressures of managing one of the largest portfolios in the world are tremendous. If hedge fund managers could take home up to a billion dollars in compensation, the one million Read takes is chump change. Nonetheless, calpers is a state agency with its own board, and it does make us taxpayer wince every time we hear about million dollar state employee salaries.

CG and oversees investments

Its one thing to compare CG of US listed companies, but its a whole different game when dealing with foreign investments. Each country, especially in emerging markets has a varying level of CG enforcement – while the general concurrence is that they keep improving each year, there being no global watchdog agency like SEC and no global standards like SOX, result in varying levels of trust in foreign companies’ disclosures. Calpers investments are currently 55% domestic and 45% foreign, but they are expected to reverse in the next three years to 45% domestic and 55% foreign. This illustrates two things – firstly, when Businessweek reports the tremendous FDI in emerging markets, we can safely assume Calpers has some part in it and secondly, this reveals how distrusting public funds are of domestic returns. While I don’t argue that money always flows where there are returns, I still believe that a public fund must have some moral and fiducial duty towards the domestic market. Even if Calpers hedges all its exchange-rate risk through swaps, and it invests indirectly through other money managers, given the risk of rising negative cash flows, it must exercise much caution in emerging markets.

Sudan and Iraq

Another eye-opener for me – divesting in outlawed countries. Apparently, Arnold has been kind enough to sign off on bills that would require retraction from any investments in firms doing business in Sudan and Iraq for obvious reasons. I have to express my sympathies to Dennis’ 17-member team that has to dig through thousands of its investments in order to determine which companies have operations in these outlawed nations. While noble in its cause, this is a sure shot way to divest from oil companies (which are most assuredly operating in every problem country). Nonetheless, despite the bill, my gut feeling is that such divestments will take a rather long time to implement, by when these nations should have stabilized anyway.

Passive or Passive-Aggressive

Each year, when Calpers releases its annual statements, the general notion that is moving from passive investing to aggressive investing is more than resounding. While the CG group is still domestic and more-or-less passive, the share of funds that are committed to alternative investments (private equity, mezzanine funds, LBOs, etc) are only increasing. Makes me wonder, if in a few years, we will be seeing Calpers as more of a mutual fund than a pension fund. Another thing that constantly bothers me is that, with recent beatings in giants like Merrill, Citi and Bear Stearns over CDOs and SIVs, I an not hearing anything from Calpers as to how much it needs to take down from its value because of its alternative investments. Agreed that there will be some reported losses from its investments in home-builders and mortgage firms, but I wonder if they are ever going to be able to account for the losses from their alternative investments.