Blowing Bubbles

Well, I’ve managed to survive another Christmas silly season where I managed to disregard most of the lessons in good decision making that I’ve taken care to explain in a series of blogs over the past year.

The first ever blog I posted was about the benefits of delaying gratification, but as I’ve added about seven pounds in weight in the past three weeks, it’s safe to say that I have ignored that one.

In February I wrote a post called ‘making your mind up’ that explained a whole range of emotional biases that affect our ability to act rationally and make informed decisions. But then I received a present for Christmas that demonstrates one life choice that is anything but informed – I got a ticket to see my team, West Ham, play Arsenal in the league.

There aren’t many choices that you make at primary school, that convention states you cannot change for life, but your choice of football team is one of them. And remarkably, since then, the only time my loyalty was sorely tested was when as a nine year old I suffered at school the Monday after a 6-1 drubbing by the same Arsenal. Arsenal fans can view the carnage here.

Fortunately, for the current game the West Ham team are a little more robust – and were even above Arsenal in the league….at the start of the game. And the cost for a front row seat in a tired East Stand? £75.

Now £75 is what you’d pay to see the latest West End musical, but at a football match you are expected to do the singing yourself. You also don’t know whether you are paying to see a comedy, tragedy or thriller.

As it turned out, one of the linesmen was a comic, West Ham’s early disallowed goal a tragedy and the game a thriller as we lost 1-2 to the old foe. But then, I am demonstrating those biases again.. time to get back to the day job.

The West Ham bubble machine in full flow...
The West Ham bubble machine in full flow…

 

 

Central Banks Blowing Bubbles


Being in the front row at West Ham I got to see the bubble making machine in all its glory.

On a more serious note the Central Banks around the world have their own more serious version called QE (quantitative easing) or simply ‘money printing’.

QE  by certain central banks began in earnest in the teeth of the financial crisis and you might think that printing money, albeit digitally, out of thin air would be very damaging to the credibility of the money in all our pockets.

And normally it would, but in this case the central banks were using the created money to buy assets, especially their own government bonds in order to bring stability and order to markets.

At the height of the crisis it also became clear that many leading financial institutions were under threat and that they could not be dismantled in an orderly fashion and the existence of QE money provided reassurance these institutions would not fail and their underlying assets could be supported.

It was the right decision, but we must remember that it was a right decision after some very poor ones by the same central banks that encouraged the excesses in the first place.

But it is one thing to print money to bring temporary support for asset prices, it is quite another to pursue the same policy further to raise the price of all asset classes, including equities, in the belief that this will encourage self-fulfilling economic activity.

This is the opposite of the normal relationship and the problem was eloquently described by Jim Grant, a financial journalist, who I have followed for almost thrity years. In a recent speech he explained, ‘we have entertained the fantasy that high asset prices made for prosperity, rather than the other way around’.

And this is where we are now. By historical measures both government bonds and equities are very expensive and although in the leading economies they are relatively stable there are signs of fissures elsewhere – especially in certain currencies and commodities.

I see the message repeated often in the world of financial advice that stability, as measured by volatility, means low risk – but that can change and change abruptly. And a general lack of understanding of the limitations of this methodology is partly why banks got in such a mess in the first place.

What this means is that, when working with clients, extra care must be taken with the level of risk being undertaken – whether looking at a client’s own attitude to risk or the risk inherent in certain assets and products.

And with the new pension rules due this year and an accompanying list of new product offerings including peer-to-peer loans, I will certainly aim to keep our clients as informed as possible.

While a prosperous New Year is great, we are after a prosperous long term.

 

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing

Two Not So New Year’s Resolutions

It seems both I and the Financial Stability Board have made new resolutions, albeit a bit late in the year.

In my case the resolution is quite a simple one – when leaving your car at the garage to have a new tyre fitted, make sure that you have ejected the cassette from the deck before handing over the keys to the mechanic.

Your first thought is probably, how come he still has a car old enough to have a cassette deck? Well these Volvos refuse to rust and back when I bought it in ’98 you got a cassette deck with your FM/AM radio and cd player.

The day before my trip to the garage I’d taken my daughter back to university. And for a bit of fun I’d found an old cassette that we last played years ago on long journeys to entertain her and her sister. It’s called ‘Disney’s Silly Songs’, and it includes such classics as, ‘There’s A Hole In The Bottom Of The Sea’, ‘When I See An Elephant Fly’ and that mind-melting masterpiece, ‘I’m My Own Grandpa’.

And we did find it very entertaining. Although, it’s rather worrying how you can remember both the words and the order of the tracks of an old children’s cassette, but can’t remember sometimes why you opened a fridge door.

The following day, on my trip to the garage, I thought I’d give the cassette one last sentimental play before storing it forever in a drawer.

As I arrived at the garage I was able to pull straight into one of the bays. Engine off, I handed the keys to a nice Polish gentleman and left to run a few errands around town to kill 15 minutes.

When I returned, the car had been moved so they could service a different one and as I paid the mechanic he thanked me and said in his thick accent, ‘Hey, by the way – nice tunes!’. And then I realised my mistake. This is what he was listening to as he moved the car – sing along:

 

Resolution solution?


 

Mark Carney
Mark Carney hopes to have found a ‘resolution solution’. Image from FSB website.

I have to admit that the Financial Stability Board’s own resolution announcement is somewhat more important than my own.

The FSB is an international body, chaired by Mark Carney the Bank of England Governor and yesterday it unveiled proposals for ending ‘Too Big To Fail’ banks. And those proposals are largely concerned with a process known as ‘resolution’.

Resolution is a means by which an institution can be orderly wound down and it is absolutely fundamental to the correct functioning of an economy. It should provide a protective legal framework within which losses can be calculated and correctly attributed to those who have assumed risk by taking a stake or lending money to a company i.e its shareholders first, then other grades of debt holders. It should also place severe restrictions on the boards of the affected companies e.g. in relation to their own remuneration.

And the key word in that last paragraph was ‘orderly’, because in the years leading up to the crisis the balance sheets of many financial institutions had become far too complex and crucially far too large in relation to their assets to be ‘resolved’ in an orderly fashion.

Initially, when severe signs of stress started to appear at smaller institutions, resolution was avoided by governments allowing takeovers by larger banks that otherwise would not be allowed under competition rules.  Some are still the subject of shareholder litigation today e.g. Lloyds takeover of HBOS.

Too big to fail

But when Lehman Bros., one of the larger financial institutions approached bankruptcy its balance sheet was so large, international, complex and leveraged other suitors for the company would only consider taking it on with heavy government guarantees. And they weren’t forthcoming as the US authorities wanted to avoid creating ‘moral hazard’ by rewarding those who had failed in their fiduciary duty.

At the time the US had a good record of orderly resolution of several failing institutions, but it was immediately clear that winding down Lehman would not be a straightforward process. Nor would it be for similar institutions which were now also rumoured to be on the brink of failure.

What Lehman had demonstrated was that troubled large financial institutions, where even their own board could not quantify all their risk, could only exist at that time with government support. And if they failed there’d be chaos – they had become ‘too big to fail’. So governments began to support other financial institutions in a variety of ways.

I won’t go into the nature of all that government and taxpayer support, but not all of it was about injecting and lending cheap funds. Some of it was about supporting the prices of those assets held by banks using policies including quantitative easing. As a transfer of wealth, some of that activity in the early months of the crisis was frankly obscene.

So, yesterday’s announcement by the Financial Stability Board is very welcome. If implemented properly it will form a vital part of the necessary reforms to banking that include transparency, counterparty risk and remuneration.

It isn’t an absolute guarantee, but it does require banks to maintain a ‘living will’ that essentially shows a true reflection of their assets and liabilities in the event of death.

And that ‘will’ should make it very clear that those who have liabilities with the bank in question are to form an orderly queue to meet their obligations, with shareholders at the front and depositors at the very rear (above the £85k limit).

A ‘Total Loss Absorbancy Capacity’ (TLAC) measure for each bank should also demonstrate how well that queue is being maintained. And new products such as CoCo bonds, that I wrote about here, are part of that overall process.

The exact details of the TLAC are, of course, complicated, but if you can get your head around the lyrics to ‘I’m My Own Grandpa’ you’ll have no problem understanding, at least, some of them.

 

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing

Peering into Peer to Peer Lending – part two


I apologise again for the length of these last two posts, but these will soon be eligible ISA investments and advice is unregulated at present. In due course, I’ll produce a more comprehensive guide – if you are interested just email me.


I mentioned in my last blog that I certainly have admiration for those who are responsible for getting the peer-to-peer (p2p) industry in the UK to where it is today. Over £500 million in loans were matched in the first half of this year and it is now regulated by the Financial Conduct Authority.

And there are plans to make p2p loans allowable investments for ISAs from April of next year. The latest consultation, containing 24 questions, was announced by the Treasury on Friday and the delay in this post is in part due to waiting for its release.

Much of this nascent industry’s growth is put down to its positive image as an alternative to traditional banking. And while that may be a real cause-celebre for a lot of lenders and borrowers matched in this way, they are also benefitting from a rather fundamental thing – price. Borrowers are paying less interest and lenders are receiving more.

But, lenders are also taking on two significant types of risk, credit risk and liquidity risk. Depositors in a bank may earn less for similar time frames and there may be certain access restrictions, but within the FSCS limit of £85,000 they know they are getting their money back.

Both of the leading p2p companies, Zopa and RateSetter, look to mitigate credit risk, the risk that borrowers default on their loans, by offering protection funds. These are pools of money, funded by fees paid by borrowers that aim to meet in full the costs of expected defaults according to each company’s own risk models.

And to date they have. Both Zopa’s Safeguard Fund and RateSetter’s Provision Fund have 100% records – in other words, all default losses to date have been met by the capital buffers in their respective funds. Zopa has even lowered the level of contributions as its overall rates of default have been so low – it claims to have the lowest default rate, including the high street banks, although I do not know if they are strictly comparing like for like.

 

I mentioned in my last blog what they’ve got right, but what could go wrong?


Well the main concern has to be that these products and their protection funds have only been operating over a short time frame economically – RateSetter was established in 2010 and although Zopa is several years older, it’s Safeguard Fund is only a year old. The corresponding period also happens to have been one of the most benign environments for consumer lending.

And there is a danger that in such an environment confidence in their own credit risk models becomes self-reinforcing. Rather than creating a larger loss buffer that might work better over a full economic cycle, it could be they are set at a level that suggests near term default rates are the best indicator of future ones.

At present, it looks as though Zopa’s buffer is set about 1.5% of loans outstanding. But, during the financial crisis, albeit with a far smaller loan book, their website shows a default rate of 5%. Of course, they may have improved their risk analysis since then and it’s important to appreciate those conditions are viewed by many as a once in a lifetime extreme event.

But it wasn’t an extreme event in terms of the level of interest rates in the UK, and I know Zopa haven’t used consumer lending data from before they were established in their risk analysis, because I asked their CEO, Giles Andrews this summer at a FT conference.

We are also still in the midst of a false environment where interest rates are at generational lows due to central bank intervention. They would like to roll that back gently, but they may not get that wish given recent volatility.

As a comparison commercial banks are required to hold buffers of nearer 10% against potential loan losses over a full economic cycle. But, and it is a big but, loans extended by banks are somewhat different because banks are allowed to use leverage i.e. lend more money than they have in deposits or other assets. They also have a broader range of lending from short term retail loans to long term commercial mortgages.

 

Understanding liquidity risk


The second major concern is liquidity – the ability to get quick access to your money by selling your loans to another investor. Both p2p providers have plans in place to enable lenders to do this for a fee – in Zopa’s case 1%. And it all sounds very straightforward and, at present, I am sure it is.

But your ability to sell your loan on to someone else, depends on there being another willing lender. If the market interest rates for the type of loans you are holding have risen you will have to pay the balance in interest to the new holder of those loans. And the availability of other willing lenders may be affected by a variety of things, such a sudden increase in default rates, interest rates in general or a loss of confidence due to problems at another p2p provider.

So, there are no guarantees to return money within a given time frame, even though at present it may work well. And this liquidity in what is known as the ‘secondary market’ in p2p loans is at the centre of a lot of the questions about their eligibility for ISAs – all other eligible investments have established secondary markets i.e they can be bought and sold relatively easily.

 

The market is evolving.


What began as a matchmaking service for individual lenders to meet individual borrowers has begun to change. New institutional lenders are now being catered for that are looking for packages of bespoke loans. This is particularly true in the States, where the FT reports that the two leading p2p firms Lending Club and Prosper are each about to package loans so that they can be sold as a single security, complete with a credit rating.

This has all sorts of implications, but as far a retail investors are concerned the regulator needs to ensure that they are not being disadvantaged as what is effectively a marketplace in these loans develops

What's good for love is good for finance. Behavioural techniques used to match couples will be adapted to match lenders and borrowers.
What’s good for love is good for finance. Behavioural techniques used to match couples will be adapted to match lenders and borrowers.

If you think this is all sounds very corporate and far removed from the original ethos of the p2p business model. I’d note that a new p2p company in the US called Payoff has just hired Galen Buckwalter, the brain behind the compatibility matching engine for eHarmony, the dating website (hat tip to the FT for that snippet). He’ll be introducing a bit of behavioural science into their loan assessments, no doubt based on the lessons of love. Aww.

 

Apparently money does grow on trees


I am already way, way over my allotted blog word limit, but I want to emphasise that I am not against p2p lending at all. Any regulated competition for high street banks is welcome. And there are other parts of Europe, especially Italy, where the traditional banking credit lines are broken and new sources of credit for their small and medium sized firms and consumers are really needed.

I just want to emphasise that while returns from this type of lending are very seductive, particularly as they can be structured to pay out in the same style as a plain annuity. And you need to be aware of risks, especially as the current p2p investment environment is so welcoming – by the companies themselves, the government and the FCA.

And it’s worth noting that, while these firms are now regulated by the FCA, under the current regulatory regime, not all regulation is the same. The provision of advice to lenders/savers on entering into a peer-to-peer loan is not a regulated activity.

Here’s Zopa suggesting money can grow on trees.

For clients interesting in learning more, please feel free to contact me for more comprehensive analysis. The information contained in this blog draws, in part, on information gained during the excellent FT sponsored Camp Alphaville event this summer.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time, so it is quite possible to get back less than what you put in, depending upon timing

Peering into Peer to Peer Lending


This is the first of two posts that are going to be long on detail and short on humour,  but the subject matter is important and I don’t think it’s been covered very well for retail investors unless you happen to read the FT on a regular basis.


This year is setting up to be a transformative year for peer-to-peer lending (p2p) – an area of finance that began matching individual lenders and borrowers using the advantages of the internet.

It now has its own body, The Peer-to-Peer Finance Association, which announced at the end of July that UK lending platforms had arranged over £500 million in new loans in the first half of the year. And, after much lobbying from the p2p industry, it became regulated by the FCA on the 1st April.

But the biggest impetus for growth was highlighted by Giles Andrews, Chief Executive of one of the market leaders, Zopa. In a Reuters article he noted, “The peer-to-peer industry is growing faster than ever and we’re looking forward to offering new products like ISAs in the near future”. He was referring to the Spring Budget when it was announced that p2p loans would be eligible investments for ISAs from April next year, although the exact structure has yet to be announced.

Zopa pioneered the model for p2p in 2004 by providing the original platform where personal savers could be matched with personal borrowers. In doing so, by cutting out banks, both savers and borrowers could get better rates. But there is naturally a concern about the risk of default involved in this direct funding model, especially as these are personal loans and they are unsecured (not guaranteed against an asset).

If you are making unsecured loans, your first defence is that you know enough about the borrower and that you are the getting the right rate of interest. But Zopa does more than screen borrowers for their chance of default, it also allows loans to be split between many borrowers to spread risk. And an internet based platform is ideal for bringing all those factors together.

It also means you can tailor pools of loans with different risk profiles for lenders with different appetites for risk. And this was the dominant model until 2010 when a competitor called RateSetter was launched.

It offered simplicity and an additional way to help manage risk to reassure lenders further. It charges borrowers a small fee that together add up to what it calls its Provision Fund to meet the likely costs of default. And since launch that fund has been sufficient to meet any losses.

RateSetter also looks more like a saving site. And now so does Zopa, which since May of last year has its own default protection fund called Safeguard. Again, it has met all its default claims so far. Both companies explicitly state that loans/savings are not covered by the Financial Services Compensation Scheme, but they are doing their best to give you peace of mind with this part of their overall offering.

So what to make of this relatively new and rapidly growing part of the investment landscape?

Well, I first have to state my admiration for those involved in getting these companies to where they are now. There have been some small failures at other companies, but these two are well established, regulated and growing. I should also point out that there are other p2p companies specialising in areas other than retail loans – one called Funding Circle has a successful model lending to smaller businesses.

They are all, no doubt, benefitting from a general desire to move away from banks. But I think that does them a disservice. Their main attractiveness is price and the nature of their service – lenders and borrowers are getting better rates.

And the p2p industry clearly wants to bring this to as broad a market as possible. Hence the innovations by RateSetter to look more savings friendly, which have been mirrored by Zopa. Both their headline returns of just over 5% look enticing, especially if put in an ISA. And the ISA development is important, because outside of an ISA tax is charged on the interest earned and default losses, if there are any, aren’t deductible from those earnings.

But, as ever, there are several important things to consider. Some are to do with risk and some to do with how the market develops.

Clearly the main point is that funds are not covered by the Financial Services Compensation Scheme, but I’ll cover the other substantial points in my next blog. And it’ll be a bit different to the marketing information found on the p2p company websites.

In finance we love growth, but if you see one of these growing in your garden don't smoke it.
In finance we love growth, but if you see one of these growing in your garden don’t smoke it.

All this talk of rapid growth is reminding me that I need to remove a rather large weed from outside our bedroom window that my wife and I thought we’d let develop as we’d never seen anything like it before. It turns out to be a plant called Jameson weed or ‘datura strarmonium’ to give it its proper name. Apparently, it is a powerful hallucinogen and deliriant. And I thought our chickens that share the same area were just getting paranoid.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

Are CoCos Nuts?

I was going to write about peer-to-peer loans this week, but instead I am going to concentrate on another new type of investment that offers high headline rates of interest.  They are known as CoCos and this week the Financial Conduct Authority used a new tool in its armoury to effectively ban their sale to retail investors.

Any resemblance between myself and this coconut is purely coincidental.
Any resemblance between myself and this coconut is purely coincidental.

The ban states that contingent convertible instruments, to give CoCos their full name, are ‘risky and highly complex instruments’. And indeed they are and I certainly welcome this pre-emptive ban. If a product can’t reasonably be understood by a private retail investor or, frankly, those advising them then clearly trading in it should be restricted to those with far more experience.

But I thought I’d give you a bit of insight into what they are and why they exist. And it’s not a story about financial recklessness, quite the opposite. They are a tool intended to aid financial stability – although with billions now in existence, that has yet to be tested.

One of the great realisations of the recent crisis was that some financial institutions were ‘too big to fail’. In other words, they had become so large and so complex that if they became troubled, that trouble would quickly spread to other financial institutions and threaten the whole financial system. I have written in previous blogs about a ‘network effect’ and this made the financial sector especially vulnerable.

And the poster child of this problem was an investment bank called Lehman Bros. When it failed in 2008 it set off waves of destructive ripples through the balance sheets of other financial institutions that were more severe than regulators in the States or elsewhere expected.

They had hoped that through a process known as ‘resolution’, the bankruptcy of Lehman could actually be orderly and give confidence to the rest of the market. And it’s true to say with other failing banks this did work, such as Washington Mutual. But with Lehman, which had a large and highly leveraged international operation, it patently did not.

And that realisation meant that regulators around the world knew that, given the resolution process was so inadequate, that they would have to keep their major financial institutions alive – even if that meant providing them with vast tax payer funded loans.

Now you don’t need me to tell you how unpopular those bailouts were and remain. And institutions, such as the Bank of England have been looking at ways ever since to improve that process of resolution so that if a bank gets into trouble it can be resolved in a more orderly fashion – and without resorting to the national purse.

To do that it wants to insure that, not only do banks have sufficient capital as a buffer against losses, but also that those who provide that capital via loans (bonds) and equity (shares) know that if that buffer gets depleted they are first in line to meet those losses – not depositors, not those who have lent the bank money that is secured against an asset for example and not tax payers.

So how do CoCos make this process more orderly? Well, the buffer I mentioned above is officially known as Tier 1 capital and a loan to a bank that helps meet this buffer has very little protection in the event that a bank needs to use the loan to meet losses.

What then normally happens is that there is a long drawn out process where the lenders meet with the bank to see how much of their money they will get back and only when it becomes clear it will be very little will lenders reluctantly accept shares in the bank as compensation for losing the value of their loans – known as a debt for equity swap.

Now, long drawn out processes are not good for market confidence or stability. Investors like certainty and this is why the Bank of England has championed the development of CoCos, because they have this whole process already built in.

If you own a CoCo loan with a bank, you already know that if the Tier 1 capital is threatened your loan will be converted to shares in the bank. The Lloyds Bank CoCos convert if the Tier 1 capital falls to 5%. And from the Bank of England’s perspective, they have control over this simplified process as they are responsible for announcing the conversion has been triggered.

It also ensures that at exactly the time that a troubled bank needs the benefit of swapping a loan for shares it is able to do so. You could call it repayment insurance for the original loan.

One of the proponents for these types of convertible loans or bonds is Andrew Haldane, the Executive Director for Financial Stablility at the Bank of England. He laid out the case for their use in banking and other areas in a speech titled ‘Debt Hangover’ in 2010.

I got to hear him speak on the more recent topic of ‘This Market’s Nut’s’ at Camp Alphaville, which I mentioned in my last blog. He was one of several speakers on the topic and it was not his choice of title, but there was clearly awareness that all this liquidity central banks have created, coupled with a low interest rate environment have led to a chase for high interest rate investments – whatever the risk profile.

And I suspect this is also in part where this ban has come from. Not only do the Bank of England and the FCA want to avoid poorly informed investors holding such products at this time, but if the Bank of England ever pulls the conversion trigger on one of these loans they do not want to be dealing with a bunch of retail investors claiming they never understood the risks.

Far better to be dealing with experienced investors, used to valuing other complicated hybrid investments such as convertible bonds – my own specialist area for several years.

And even where investments are allowed it’s important to know their limitations or know someone who does. And this whole series of blogs is designed to help you do that. It’s so easy to get over confident as I have mentioned before.

My wife and I still have the emotional scars from the time, given a background in art, I offered to apply her makeup for her. I was hoping for the subtle look of Coco Chanel, but she got the more distinct appearance of Coco the Clown. The pictures are here.

But that’s enough cocos for one day!

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

Gone Camping – Robots, Fraud and Peer to Peer Lending

Most of the posts in this series have been aimed at making you more informed about investment in general. And I take a rather different approach than just putting some charts and tables in front of you that all contain rosy examples.

Before you even start investing I want you to understand a bit more about the risks involved in decision making and how the economic world is wired. And I draw in part from my own experience and knowledge, but also from my own ongoing research which involves a lot of reading.

But I also make a point of attending seminars where I think I can learn something. And that normally means ones where leading investment groups and fund managers also attend hoping to do the same – but where I very rarely meet another financial adviser.

So a few weeks ago I headed off to London to a large tent in the grounds of the HAC (Honorable Artillery Company) to attend the first ‘Camp Alphaville’, hosted by Financial Times Live. Alphaville is, in the FT’s own words, their own ‘irreverent financial blog’ and is part of the online edition of the FT.

(The ‘alpha’ part of the name is what we are supposed to paying fund managers for – investment returns above that expected for the amount of risk taken. Some might call it skill, others luck.)

Large tents sometimes come with clowns inside and proceedings got off to an inauspicious start as two members of the audience started swinging at each other. Why? I have no idea. I initially thought it was a pre-arranged side-show, but no, they had taken a genuine dislike to each other. They clearly hadn’t read the promotional slogan for the event of ‘Peace. Love. Higher Returns’.

After their early eviction, we were left with a variety of investors, strategists, bloggers and policy makers discussing a variety of topics across one main stage and four inflatable ‘igloos’. Most of the speakers were in person, but some appeared in the form of an AwaBot telepresence robot – which is basically a tablet with front facing camera on a movable base, which is controlled by the person on the tablet screen.

What is the collective noun for a group of AwaBots?
What is the collective noun for a group of AwaBots?

I have to say, I think this form of remote control skype on wheels will take a bit of getting used to. One of the robot controllers explained later that one lady, thinking that the screen was just a TV on a stand, used its reflection to adjust her bra – he chose not to say anything and look away. And what if you were enjoying a quiet drink in a bar, when one of these rolls up controlled by your better half and asking when you will be home?

While I may have had some reservations about the AwaBots, they did fit with one of the main themes of the event – how robots could disrupt the labour force. Other leading subjects were China and its outlook, how markets have gone nuts and the rise of digital currencies. And on this last topic, which is very interesting, at times mind-melting and largely about Bitcoin, I’d note that we were asked to bring good old fashioned cash to pay for food and drinks.

My main focus, however, was elsewhere. I was intent on meeting two gentleman from different companies that have had considerable success at spotting fraud at listed companies. I also wanted to attend a debate on peer to peer lending. And I’m pleased to say I managed all three.

Why the interest in fraud? It’s simple, you’ll learn more from those who spot when things go wrong and there are simple lessons to be learned from both Carson Block of Muddy Waters fame and John Hempton of Bronte Capital. Spotting fraud can be a long drawn out and difficult process and there’s no question in my mind they are creating genuine alpha for their investors.

They are very different characters, but they share an understanding to always question the apparent hard facts in front of them, ask themselves constantly are we wrong in some way and perhaps the most glaring point for me, they are used to getting their hands dirty – something one can only hope the economist community does more of.

When I say getting their hands dirty, I mean what you might imagine to be rather simple stuff like tracking the activities of known fraudsters to see where they surface next. Checking the authenticity of published documents or perhaps the credibility of auditors. Looking at the meta-data on published reports to see if dates have been changed and even hiring students to count lorries entering and leaving factories to see if a company really is doing the amount of business they say they are.

Of course, this takes time and costs money and doesn’t fit with an investing world dominated by spreadsheets and a blind trust in theoretical models. And that is why they have an ‘edge’.

But it’s not just about looking for fraud, the same approach is used when investing in companies that others might hate. In an ironic twist John Hempton’s fund has invested in a US drink and food supplement company called Herbalife, which has itself been accused of being a pyramid scheme by a leading hedge fund manager. This is an ongoing situation and you can read about it at length in John Hempton’s blog, which is necessarily a bit technical.

He told me this stock has been his best performer in the past year and as he explains in his blog his edge is that he has made the effort to visit Herbalife distributers and the weight loss classes they hold in several countries and has concluded the business is largely real. He may yet be wrong, legislators in the States may take a different view, but he has been very thorough and well rewarded to date.

Finally, I headed for the debate on peer to peer lending. There are plans by the Treasury to make these direct loans between peers (eg. consumer to consumer), as an eligible ISA investment. And I did get into a bit of a discussion about risk with a board member of one the longest established firms, Zopa. We were a little bit at crossed purposes, but as someone who used to deal with the most complicated forms of corporate debt I was trying to learn as much as I could about how they assessed the risk of their loans. But, I’ll leave much of what I learned for next week.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

 

 

It’s a Small World – Part Two, ‘What’s the chance of that happening?’

chanceIn the first of these two blog posts, I highlighted how good and bad economic events are much more likely than you might expect. And this is partly due to the way the economic world is wired. There is a ‘network effect’ that also applies to many other complicated systems, such as our bodies.

I also described how some students in the States had developed a game that demonstrates this effect called the ‘Bacon Game’. The game is based upon linking actors to Kevin Bacon, either through appearing in the same movie as him or having acted with someone who has….and so on. And what we discover is that the acting universe is far more connected to the star of such movie greats as ‘Tremors’, than we would think if they only knew each other randomly.

But this second blog is about how, even if things did just happen randomly in the same way as tossing a coin or rolling a dice, unlikely events still happen more often than we expect. Or to put it another way, when the world gets as big and complicated as it is, coincidences are very likely even though we might imagine that the chances of them happening are extremely small.

Now I am not attempting to rubbish any beliefs you might have about ideas such as fate, for example. I am merely demonstrating that we ought to consider how likely coincidences are before we assign them any special spiritual or paranormal significance.

And in investing terms, it means that yours truly is especially sceptical when looking at a presentation from an expensive fund manager showing magnificent potential returns for my clients. After checking whether I think the data is real, I then need to consider whether they’ve just been lucky. Maybe they have just been ‘fooled by randomness’ as Nassim Taleb put it in the book of the same name.

One of the best examples used to demonstrate how more likely coincidences are than we expect is this question – What is the chance that two children in the same class at school have the same birthday? Statisticians know this question as the ‘birthday problem’ or ‘birthday paradox’.

And the answer?

Well, assume there are 30 kids in a class and that birthdays are evenly spread over the year. Given there are 365 days in a year, the answer would seem pretty unlikely. But, the mistake we make is that we tend to think in terms of any two children sharing a specific date such as the 12th November, rather than the chance of sharing any date in the year.

The answer is 50% – actually, it’s a little over a half as you only need a class of 23 to get a chance of 50%. Or to put it differently, if we had two classes of children, we would expect one of the classes to have two children sharing a birthday.

There are several ways of calculating this theoretically and if you contact me I can send the most straightforward one to you. But, we can also get the same answer using a mathematical technique of trial and error called a ‘Monte Carlo simulation’.

If you create a column of 23 random dates in an excel spreadsheet and keep hitting the F9 key to recalculate those random dates, you’ll find that half the time two of those 23 dates will match. This is a very simple example of this technique and I use it far more extensively when making financial plans.

Of course, the other option is to ask your own children or remember your own school days. And at my school I was that kid in my maths class that shared their birthday with a girl in the same class. I don’t think my teacher appreciated the statistical likelihood of that outcome – he was just demonstrating data selection techniques and had come up with his own early version of a dating service using holes punched in cards.

Alas, while his experiment was a perfect example of the’ birthday problem’, as an exercise in matchmaking it didn’t work. We’d have been a pretty odd couple. The girl in question was six inches taller than me at the time and went on to become a national karate champion – I was more into art.

I did, however, marry the girl in the next classroom whose birthday is two days after mine. And here we are together over 30 years later – what’s the chance of that happening?

Apparently, a little more that I’d give Sheldon and Amy in the ‘Big Bang Theory’.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

It’s A Small World : Part One, ‘The Bacon Game’

This is the first of two blogs that will show you why it is a small world after all.

The world and its economy is far more connected that you might imagine. And while that does have some negative consequences, it also provides considerable benefit for the general growth of the economy and that is particularly rewarding for long term investors.

It might be my least favourite ride at Tokyo Disney Resort, but it is a small world after all.
It might be my least favourite ride at Tokyo Disney Resort, but it is a small world after all.

Normally, I tend to go a little ‘off-piste’ at this point in the hope that I can maintain your interest. However, in this case I am fortunate that, 20 years ago, three Albright college students did that for me when they dreamt up a game that very effectively demonstrates how complex systems, like the economy, benefit from a network effect. It is known as the ‘Six Degrees of Kevin Bacon’.

The aim of the game is to discover how connected any Hollywood actor is to Kevin Bacon – the hero of such cinematic treats as ‘Tremors’, which I admit is only good because it is so bad. The idea is to work out the shortest number of links or ‘degrees’ between any random actor and Kevin.

If the actor and Mr Bacon have appeared in the same movie, that’s one degree of separation. If the random actor was not in a film with our star, but appeared in another movie with an actor who has appeared with him, that’s two degrees – and so on.

So, you might ask, how well connected is the movie world in this way?

In his excellent book, ‘The Origin of Wealth’, Eric D. Beinhocker describes a study using data from several US universities that show the highest degree or ‘Bacon’ number for any American actor is 4. He goes on to state, ‘90% of the roughly 570,000 actors in the world had some connection to Bacon, the highest Bacon number in the world was ten, and 85% had a number of three or less.’

Those are pretty amazing numbers. And it shows that the movie world and, by extension, the economic world is far more ‘connected’ than you would expect if the links were just random.

Why is this the case?

When you have lots of different clusters of people linked by different themes, such as their profession and then have random links between those clusters you get much better connections than by random chance alone.

It is possible to quantify this mathematically and two gentlemen Newman and Watts have shown that in a population of 1000 people if each person has 10 friends and 25% of them are random, then the average degree of separation is only 3.6. If each person has 10 friends and none are random, it’s 50!

In light of those numbers, it’s easier to see how social media companies like Facebook grew so quickly using the biggest economic network, the internet. And Facebook uses its considerable knowledge of its own network structure and its connectivity to entice advertisers. It also, in part, explains some of the extraordinary valuations of companies in the sector and why a simple application like Snapchat spurned a $3 billion offer from Facebook – but I stress, only ‘in part’. Some of these companies are priced as though they will achieve networking perfection and late investors are very likely to be disappointed.

And, of course, not all network effects are beneficial – the recent financial crisis laid bare the dangers of contagion and that in extreme environments, different types of investment are far more linked that we would like or that traditional theory suggests. Which leads me back to my previous blog about volatility. Simply put, market prices and movements are showing real signs of complacency.

I’ll leave you with a short video of Kevin Bacon, who given his networking credentials fronts the current advertising campaign of the EE mobile and broadband network. Here he is challenging Jamie ‘never wash your hands’ Oliver to make the best bacon sandwich.

And I’d really appreciate it If you could help me add to the ‘small world’ network effect by clicking the ‘like’ button at the end of this blog.

Please remember:

  • past performance is no guide or guarantee of future returns;
  • the value of stock market investments can rise and fall over time,  so it is quite possible to get back less than what you put in, depending upon timing

An Introduction to VIX – the Fear Index


If I said to you the word ‘Vix’, chances are you would be thinking that I was talking about ‘Vaporub’. However, in this case I am referring to one way in which we measure how ‘fearful’ financial markets are.


Not that Vicks Vaporub doesn’t have its uses in life. Aside from the obvious one of relieving nasal congestion it also serves as a reasonable clue to the health of a marriage. If you are happy sharing a bed with a sniffling partner covered in the stuff, chances are you’re both onto a good thing.

The Vix measures emotion between these two extemes. Pick a button.
The Vix measures emotion between these two extemes. Pick a button.

To give it its full title, VIX refers to the Chicago Board Options Exchange Market Volatility Index. That sounds very grand and a bit complicated, but as ever, I’ll try to break it down into a simple concept that is easier to understand. And I’ll leave most of the mathematics to those of you who want to contact me directly for a much fuller explanation.

The ‘options’ referred to in the title are essentially just price guarantees that can be traded for a fee. Some allow you to guarantee the price at which you can buy the stock index – others give you a guarantee to sell at a certain price.

And it’s the fee, or premium that you have to pay that gives us a clue to how relaxed or fearful the overall stock market is.

Why? Well if I am going to provide you with any form of guarantee, whether it’s on a household good or perhaps the insurance on a car, I need to work out how likely it is that I will have to pay out that guarantee and whether, on average, it will cost more that the fees I am charging.

When it comes to a stock index, the chance that I will have to pay out depends largely on one factor, how volatile that stock market is, or more importantly, how volatile it is expected to become. The more wildly it is moving around, the more likely that I will have to pay out on the guarantee and therefore the more I want to charge upfront for providing it.

And that is what the VIX attempts to do. It looks at the prices being charged in the market for a variety of options or price guarantees and comes up with a value that tells us how volatile those prices are telling us the stock index is expected to be. And that number is a percentage of the current stock index price.

A figure of 20% means that there is almost a two thirds chance that the market will remain in a range up or down 20% in the next year. A lower figure would mean that expectations are for a much calmer market, a higher figure for a more volatile market.

And at the moment the figure is a mere 11%, which is very low – the lowest level in fact since the start of the financial crisis in 2007. Then it was a spectacular misjudgement given what happened over the next two years.

 

But are current levels justified?


There are all sorts of indicators that are suggesting the financial markets are having one enormous ‘goldfish’ moment where they have completely forgotten the last business cycle. And the reason for this is extreme confidence in the actions of the central banks.

I am nowhere near as sure as to the level of their competence, but low expectations of volatility can last for a long time – you know that it will increase but it is very hard to say when. As I’ve mentioned several times, it suggests it’s time to be a bit more cautious. It also means that I am finally prepared to look at some defensive structured products, but that will be on an individual client basis.

And I repeat that if you’re into natural logs (mathematical not fire wood), rules of dispersion, letters of the Greek alphabet and want to pick the brains of a volatility watcher since 1985 – I’d be happy to answer your questions.

 

 It’s all part of the service.


Answering your questions is all part of the service, and living eight years in Asia gives you an insight into great service. Here is a short topical story about the service I received during the 1990 Italian World Cup, while staying at the Oriental Hotel, Bangkok.

My wife and I were there to spend a delayed honeymoon in the splendour of this fine hotel. Our original honeymoon was just a couple of days in Bournemouth and as exotic as that location is, we felt we deserved another break.

The problem was it was during the World Cup and given the time difference between Bangkok and Rome I needed to know the Oriental Hotel was putting the games on in the early hours.

I needn’t have worried. The Thais are fanatical about football. And I realised this when on the day of England’s first game against Ireland I entered the designated room at the hotel.

There was a huge projector screen at one end and about one hundred chairs in front of it and about the same number of staff standing around the edges of the room that refused to sit down even when I invited them to – and I was the only hotel guest there.

It was a rather bizarre environment. As the game started none of the staff made a sound, so nor did I. Then a senior looking member of staff came over to me and said, ‘excuse me sir, are you English or Irish?’

I replied, ‘English’ and he returned to the other staff to let them know.

The next time England got the ball, they all cheered, and when Lineker scored after 8 minutes I could have been on the terraces. It finished 1-1, but believe me when I tell you it’s hard to match Asia for service!

Sex & Drugs & GDP

On a trip to the coast a fortnight ago, I went inside a café to order a couple of ice-cream cones. Ahead of me in the queue was a father, who was looking a little stressed. He was waiting for a few burgers and hotdogs for his family and it was taking a little longer than expected.

He wasn’t the only one who was a little tense. The staff were feeling the heat of the kitchen as well – and I was wondering how I managed to get on the wrong queue again. His order did finally arrive and everything seemed to relax a bit as the lady behind the counter entered his order into the digital till.

In anticipation, the dad stood there with a twenty pound note in his hand and I doubt he expected much change. However, the final total on the till suggested he had under-clubbed it a bit. The price for some soft drinks and a few burgers and hotdogs? £26,000.

A bit pricey for a few burgers and drinks.
A bit pricey for a few burgers and drinks.

 

He quite calmly said, ‘I wasn’t thinking of spending that much’. And from the back of the kitchen came a distant voice, ‘has the till gone wrong again?’

They settled on an amount nearer £15 and my own bill was a more moderate £3.20 as we resorted to the old analogue system of a notepad to record the trade and cash to pay for it.

I mention it because, for a fleeting moment there, the Gross Domestic Product (GDP) of the UK was artificially raised by approximately £25,985.

I am jesting, of course, but last week we learned that the Office for National Statistics will attempt to add the oldest industry in the economy to their quarterly estimate of how the economy is faring. From September, as part of other changes that will lift GDP by 2.3%, they will include the value of drugs and prostitution.

It’s important to emphasise the word ‘estimate’. GDP figures are reported and debated in the media as though they are factual, but they are subject to revisions as some parts of the economy are far harder to assess than others and not all the data arrives at the same time.

In this case, the Office for National Statistics kindly give us a separate Excel spreadsheet that shows us their assumptions. In total, it amounts to £9.7 billion, based on 2009 prices, or approximately 0.7% of the then GDP – and it breaks down as follows:

Prostitution        £5.27 billion        54%

Drugs                  £4.43 billion        46%

In the case of prostitution they reached that number by estimating there are 60,879 prostitutes in the UK – each with 25 clients a week paying £67.16. If £67.16 seems ridiculously precise, it’s an old figure of £50 adjusted for inflation. Take off costs of £44 million, which were borrowed from a Dutch estimate and you get the final figure.

And for the drugs industry, cocaine in its various forms represents 71% of the total (42% crack, 29% powder). Those numbers allow for the cost of importing it, so the sales figures are even higher with cocaine accounting for 77% of the grim total.

So why are they attempting to do this?

Ostensibly it is to meet European Union rules to establish common practice among member countries. The Dutch, for example, have reported parts of these figures for years as prostitution and certain drugs as are legal. However, the overall changes are also in line with international guidance from the likes of the US and Australia.

It’s hard to argue with the idea of trying to measure all areas of the economy and some countries have a lot of work to do. In April the IMF endorsed a near doubling of Nigeria’s GDP to $510 billion as new industires were added and prices updated. As the Economist newspaper pointed out, the new numbers aren’t fiddled, it’s the old numbers that were wonky.

So what’s most important is that the numbers as a whole are regarded as credible. And the numbers of two countries stand out as being questionable.

The government of Greece, endorsed by some economists, justified higher levels of national debt before the recent crisis due to the estimated size of its black economy. At the time, as now, it wasn’t even collecting normal levels of tax on its legitimate one. We know how that one turned out.

And then there’s China, where the GDP figures miraculously meet official annual targets near 7%, despite the sheer scale and complexity of their calculation. Mathematically, continuous growth of 7% is a notable number – it means the economy is doubling in size every ten years. And if an economy of that size is really growing at that rate, they are more likely to bump into problems – especially rising levels of debt.

Michael Pettis, a professor of finance at Peking University, whose blog we have followed for some time, now makes the case that it can’t continue that way – the country needs to rebalance towards lower growth nearer 3 or 4%. I’m not sure the investment world fully appreciates that.

I’ll leave the final comment to the lyrics of Ian Drury, from whom we borrowed the title of this blog. He knew a thing or two about simple explanations of complicated subjects. My favourite has to be these two verses about two well known gentlemen from ‘There Ain’t Half Been Some Clever Bastards’ –

Van Gogh did some eyeball pleasers

He must have been a pencil squeezer

He didn’t do the Mona Lisa

That was an Italian geezer.

The next verse isn’t quite as factual, but brilliant nonetheless

Einstein can’t be classed as witless

He claimed atoms were the littlest

When you did a bit of splitting-em-ness

Frighten everybody shitless