Monday 16 June 2014

The morals and ethics of finance - why (most) hedge funds aren't that evil

I used to work for an investment bank. Frankly I did things that I didn't think were 'right' although they were legal. Some of my colleagues were doing stuff that as it turns out was perhaps just a little illegal. So I left. After a brief hiatus in the real world I joined a hedge fund. You may be surprised to know that I considered this a step up in terms of re orientating my moral compass in the right direction. Bluntly I felt like I could look at myself in the mirror again.

Partly this was due to moving from a rather brutal trading floor to a more abstract ivory tower environment in which it was easy to forget that there was anything as vulgar as actual money involved. But there is far more to it than that.

I am certainly not a theologian (I would have even struggled to spell it without the aid of technology), ethicist or moralist. However my judgement is that the average hedge fund is much less likely to be involved in behaviour which I personally would find morally repugnant, compared to the average investment bank.

Let us put aside for the moment any issues of the absolute morality of the various actors on the financial stage. You may be sufficiently purist in your beliefs that you think the entire concept of the capitalist system is a big pile of dung, and the bankers and hedge funds are just the cockroaches on the top. I respect your belief, although I would respect it more if you could come up with a workable alternative. I'm a big fan of misquoting Churchill on this subject.

Democracy Capitalism is the worst form of government economic system , except for all those other forms that have been tried from time to time”
Personally I'm going to stick to a more realistic goal of trying to make capitalism a bit more warm and fuzzy. For example I think the fees banks get for doing IPO's are excessive; but I think IPO's are necessary otherwise it cuts out a range of capital raising options for businesses that may well be of use to society.

This is all besides the point as what I am interested in here is relative morals.  Perhaps we all belong in a particular circle of hell, but my argument is the average investment banker would be in a more nefarious circle than the average hedgie.

Seven Deadly sins

Its probably worth reviewing what are the main shortcomings of the average banker using an old, but still useful, classification system.

- they get paid too much (greed)
- they want to get as much or more than the next guy (envy)
- they are arrogant showoffs (pride)

(Lust, gluttony and wrath also come into the mix for many bankers, but most work pretty long hours so I don't think we can pin sloth on them as well.)

Now its probably fair to say that these are labels which you might also associate with hedge fund managers. However in my experience at least hedge fund managers tend to be much lower profile than bankers. Partly this is out of choice, but as people running high profile public companies top bankers have to have a certain amount of exposure - although many certainly go out of their way to court more. I am pretty sure that most people in the UK now know what Bob Diamond and Sir Fred Goodwin look like. At the other extreme there are probably some members of John Paulson's own extended family who wouldn't recognise him in the street, though he is arguably responsible for the biggest single gain in hedge fund history.

However I accept that you really only have my word to take for it, and this claim somehow lacks sufficient weight to be the complete defence of the hedge industry.

Actually the fundamental reason why an investment banker is more likely to do bad things than the average hedge fund manager is that they have more opportunity to do so- its just much easier for a banker to be bad.

The menu of financial immorality

Let us consider the options for someone in the financial sector wishing to do 'bad' things. Some of these are illegal as well as immoral.

Insider information

Its true that hedge fund employees have been charged with dealing on insider tips. Its also true that pretty much all that information was supplied by people working for investment banks, without whom the crime couldn't have happened, and whom were undoubtedly getting a fair cut of the proceeds. There is no natural way for someone outside a bank to get access to confidential information. However people in banks advise companies and governments on transactions as a matter of their normal business. So they have to set up processes and barriers to deal with this very potential risk. It is much easier for an investment banker to trade on inside information, because they see so much more of it.

On the legal, but perhaps not ethical, side banks also see 'order flow'. They sit as conduits for transactions from other parts of the financial system where they effectively make markets or introduce corporate funds/loans into the system and then hedge exposure; to put it another way in many places banks are the 'market makers'. Its mostly legal to take advantage of seeing that flow. Even the very largest hedge funds don't have that kind of information, at least not first hand.

Market manipulation (real price)

Market manipulation is basically trading in such a way to move prices to your benefit. Some flavours of this are legal, some aren't; and it depends on the market.  So for example you might 'spoof' by submitting a large sell order, force the market down, and then buy in at the lower price. A more complex example would be if you had a binary option (an option that only pays off a fixed amount if a price is above or below a particular point, otherwise is completely worthless) then it would be worth making loss making trades in the underlying to give the option value.

To manipulate markets you either need a very small market  or lots of money.

You might assume that hedge funds have huge amounts of money. They don't, at least not in a relative sense. A lot of hedge funds are tiny. The largest hedge fund is around $80 billion. Where do you think an $80 billion dollar fund registers in the ranking of the worlds largest fund managers (i.e. 'long only' as well as hedge funds)? In the top 10? Top 20? Top 50? In fact an $80 billion dollar fund would barely scrape into the top 150 of the worlds largest funds. That 'huge' $80 billion fund is 98% smaller than the worlds largest asset manager. Many large asset managers are owned by banks. Even this excludes the amount of assets banks hold directly, which is probably an even bigger pool of money again.

Although hedge funds have more leverage and often trade more, magnifying their impact, in most markets (though not all) they are not big enough to manipulate the market by themselves. The 'market maker' advantage that banks have in many markets, as well as seeing order flows, makes it even easier to 'adjust' prices if desired. 

It is true that hedge funds are more likely to be involved in short selling. Some people think short selling is intrinsically bad, and is always market manipulation. I disagree, but you can read the well rehearsed arguments for and against elsewhere.

Market manipulation (not really a price)

Too hard to rig the market through spoofing transactions? Why not make it easier for yourself by creating a 'fix'. This is a 'price' set by a survey or some other method which doesn't have to rely on real transactions. The best known example of this was the LIBOR fix. LIBOR was set by asking a bunch of people (the 'panel') what they thought the price of money should be without actually meaning they had to borrow or lend at that rate. Pop quiz: What proportion of the LIBOR panel are banks? What proportion are hedge funds? If you answered 100% and 0% respectively, go to the top of the class. LIBOR is / was a club which hedge managers were not invited to join. I am not aware that any hedge fund benefitted from the manipulation, but even if they did as with insider trading they could not have done so without help from an insider, at a bank.

Dealing with uninformed counterparties

Although it says caveat emptor on the label in most markets we rely on regulation to prevent people buying stuff without understanding what they are getting themselves into. In financial regulation there is an awful lot of regulation around selling to 'normal' people, but its possible to completely avoid this if you are dealing with someone who falls outside that definition. Many of these are not sophisticated investors and still need protecting in my opinion. This could be a small business, a wealthy but by no means super rich investor, or even a large pension fund. There are countless historic examples of banks taking advantage of institutions and businesses and also more recent ones (eg swaps gate and LOBOgate). The main problem is the lack of a transparent market for these kinds of transactions; this means a lack of truly competitive comparable quotes and an open invitation to get taken advantage of. There is also the problem that the counterparties often have to do the deal with somebody (eg local authority treasurers under pressure to reduce funding costs).

Hedge funds overwhelmingly deal in liquid open markets with publicly posted prices. Some markets are less transparent (eg credit derivatives) but here they trade almost entirely with banks, or occasionally with other funds.

Hedge funds do have customers -investors - and perhaps some of them don't know what they are doing. The Madoff scandal hangs over the industry like a cloud, and we can't ignore it. But there is usually a large choice of hedge funds for those who can invest in them. Pricing isn't completely transparent, but fairly so. Finally nobody is forced to invest in hedge funds.

Charging excessive fees

Uninformed counterparties often get charged excessive fees. But this deserves a separate heading as even informed counterparties can pay too much in a monopoly situation. Again the 2 and 20 fees of hedge funds are much derided given the performance on offer and in many cases the derision is deserved as 'skill' is in shorter supply than the fees would suggest. I would argue that charging 1.5% for a simple skill-less long only tracker fund is far, far worse. This is what I am being charged in a child trust fund, merely because the product category is an 'orphan' (okay, bad choice of analogy). Its also the case that banks are far more likely to be involved in products in which the fees being made are even larger and hidden from the buyer; structured products and loans with embedded derivatives for example.

Aiding and abetting 'bad stuff'

The range of businesses that banks are involved with gives them a much wider intrinsic opportunity to do things that are unethical. So hedge funds generally don't lend money to businesses. So they can't lend money to arms or tobacco firms. They can buy shares in them of course, but so can banks, and as we've discussed banks have far more financial firepower. Hedge funds don't lend people money to buy houses (though they can invest in securities linked to mortgages). They don't lend people more than they can afford and then re posses their houses when they can't pat it back. Hedge funds can't lend people money, then make them buy useless insurance to 'protect their payments'.

Be assured I do have some qualms about the hedge fund business even the relatively abstract kind that I was involved in. For example is it right to trade palm oil futures? Or in the midst of a food crisis to trade any foodstuff? Or given the environmental problems, crude oil? These are not easy questions to answer, and there are huge grey areas, but at least in a relative sense these are relatively benign moral dilemmas compared with the LIBOR scandal, swaps gate and LOBOgate.


To summarise I do not personally think that the average hedge fund manager is any more morally flawed than anyone else whose main concern is profit, including such warm and cuddly people like Sir Richard Branson (also the less cuddly but still admired Lord [Alan] Sugar). Investment bankers on the other hand have many more opportunities to be bad people, and unfortunately quite a few of them exploit those.

Ironically investment bankers are probably in a position to do more good than the average fund manager. This more complete menu of moral choices is available because banks are an integral part of the economic system, whereas hedge funds are 'just' investment vehicles.

Really though this is a numbers game. If investment banks are the cockroaches on the dung pile of capitalism then hedge funds are a tiny speck of rubbish on the back of one cockroach. Encouraging bankers to behave in a more moral and ethical way will have far more effect on the general level of morality than similarly re-educating hedge fund managers. It is not worth wasting moral outrage on the hedge fund industry. Go and pick on some bankers instead.

Tuesday 10 June 2014

Tuesday 3 June 2014

The five minute portfolio

If you make the mistake of telling people in a social situation you are 'in finance' then they will usually have a specific kind of follow up question. This is basically the equivalent of telling people you are a doctor, at which point they will ask you about this little niggle or mole that is worrying them. If you are in finance you will usually get 'Should I buy or sell X'? This post aims to answer the general question of that - what stuff should I hold in my portfolio?

To approach this problem we need to think about two questions

- Which assets I should hold?
- What proportion should I hold them in?

As a trailer for the second question I will be using some relatively interesting results using bootstrapping to optimise portfolios. So people for whom this entire question might seem trivial might want to skip ahead to the fun bit. This, and only this, is what separates this post from other 'lazy portfolios' you can find on the Internet – I will show you the 'moving parts'. 

For some other lazy portfolios this is a particularly good site and worth reading first if you really are a complete novice  

Essentially this is a post on how even quite ordinary people can make use of the results of some fairly funky quantitative techniques, without being experts. Or without having to pay for it.

Which assets should I hold?

For the first question I am going to assume a particular kind of person is doing the questioning. Since I don't tend to hang around with pension fund managers the person asking me is normally a relative novice at investment, with a relatively small amount of money and no time or interest in becoming an expert. For such a person I advocate a 'five minute portfolio'. Five minutes is how long it takes to construct, and then you might want to spend five minutes a year thinking about it. It may well take you longer than five minutes to read this initial post, but that isn't included. If you really don't want to spend any more time on this exercise then feel free to scroll to the end where the actual portfolio is shown.

First I am going to assume that you want to hold the best portfolio possible. Since the only free lunch in finance is diversification that means you want the most diversified thing possible.

If you have a relatively small amount of money I would say there is no value in holding individual stocks. The fixed costs of purchasing stocks mean that buying less than say £500 of something isn't economic. You will be lucky to pay dealing fees of £10 plus stamp duty of £2.50; so a 2.5% hit on your assets on day one. If you have £10K and you use it to buy 20 UK listed equities then you've got a portfolio that is just starting to be diversified within UK equity space; but has absolutely nothing outside UK equities. Using up those £500 chunks on individual stocks and bonds is just unnecessary.

As an individual there is also the advantage that you will feel less attachment if you aren't holding individual stocks. This abstraction is a way of reducing the cognitive bias of overconfidence and will reduce the chances of you wanting to over trade your portfolio.

I am going to assume that there is no skill in investment management, or at least that the price you pay for it isn't worth it. This puts unit trusts and investment trusts off the menu, as well as hedge funds (which in any case are inappropriate for the kind of people I meet at parties, since I don't tend to go drinking with wealthy oligarchs). Perhaps a bit harsh, especially given my former career, but this really cuts down on the menu of options and reduces the time you have to spend thinking about whether a particular portfolio manager is worth his 100bp or 2 and 20. I actually like investment trusts and you should consider using them for certain foreign holdings especially if they are trading at a discount to NAV. But the process of checking that discount bumps up the time required from 5 minutes, so bear that in mind.

So I would argue for a small relatively inexperienced investor that a highly diversified portfolio of Exchange Traded Funds (ETF's) is most appropriate. They are relatively cheap, passive trackers. Arguably this is likely to outperform in the long run a portfolio of individual stocks, particularly if they are focused on one country. Since that is all most active retail investors hold, you're already ahead of the competition.

I will ignore tax, so I don't mind if you are holding this stuff in your ISA, self invested pension, in a plain old brokerage account or in share certificates stuffed under the nearest matress. This isn't a question about which investment wrapper is best, but about which stuff you should put in your wrapper.

Which ETFs?

I am going to focus on the ETF's provided by Vanguard and iShares. This is because vanguard are very cheap on fees, but with a limited offering; and ishares have a very big offering (as well as quite a nice website) but tend to be more expensive. There are probably slightly cheaper ETF's out there and it might be worth doing the research on this. I will also assume you are a UK domiciled investor who wants to own assets listed on the London Stock Exchange only (though the funds might be listed in Ireland for example).

Disclosure: I have no connection with eithier firm, but I did partake of some iShares corporate hospitality several years ago. Other ETF's are available!

By the way this allocation amongst ETF's is something you can pay someone like nutmeg to do for you. Its not something I would personally bother with, but if five minutes is a bit too much of a commitment and you don't mind paying the additional fees involved then be my guest.

If we think about kinds of asset classes there are in the world then at the top level we potentially have:

- equities
- government bonds
- corporate bonds
- Property and land
- Foreign currency (FX)
- Commodities (Agricultural, Metals, Energies)
- Infrastructure
- Private equity / Venture capital

As an individual investor its quite hard to access many of the latter of these objects in a pure sense. The last two often require big minimum investments. In ETF land when you see these listed you are usually buying into listed companies holding these assets. This means you are just holding equity investments. Commodity indices have their own potential problems depending on if they hold the physical asset or trade futures. There is some argument over whether FX is even an asset class.

I'm also going to ignore property. This is because again the ETF's mostly include listed property equity rather than 'real' property, and also because most investors already own a house which gives them property exposure. Finally I am also ignoring various strategies 'smart beta', 'sustainability' and 'minimum volatility' ETF's. We want to keep it easy. All these more complex things also tend to be more expensive. 

The arguments about the rights and wrongs of sustainable investing is for another post. However if this does float your boat you can substitute sustainable ETF's where possible. This will reduce your choice and cost you more in fees; which may or may not be made up for in performance. I am not saying this is an ideal state of the world, just stating the facts.

So we are looking at a portfolio of:

- equities
- government bonds
- corporate bonds

For each of these I am going to want something which is geographically diversified. Ideally I would also want to be diversified around different sectors of the economy; but with a maximum of say a dozen ETF's that just won't be possible.


Portfolio optimisation 101

Do not worry if the following is gobbledygook. You can just skip ahead to the results if you find it hard going.

Considerations when allocating portfolios are:

- Expected gross return
- The correlation of returns
- The volatility of returns
- Fees

These are in order of unknowability. It is really hard to forecast returns. Correlations are a little more stable, volatility more so, and fees are known with certainty.

I am going to assume that we can't predict expected gross return. Like the rude comments about fund managers above this might be a little harsh. However this does simplify things immensely, and although there are models which do a reasonable job of forecasting returns they require some effort to implement.

To deal with fees is simple; where we have two ETF's that do roughly the same thing we will go for the cheapest. For example IUKD from ishares costs 0.4% and VUKE (Vanguard) costs 0.1% (note I am measuring fees on 'TER' which isn't perfect, but is simple). In practise this means we will use cheaper Vanguard funds for our equity ETF's, only turning to ishares for bonds.

When I actually do in my optimisation I am going to assume that everything I have has the same net Sharpe ratio, i.e. the returns scale precisely to the realised volatility. Of course this isn't quite the same as assuming the same unknown gross return and subtracting known fees; but it is neater. I am also going to assume that we have an annual risk threshold of 10%. This is about as risky as the FTSE 100 ETF returns over the last year (I will relax that assumption at the end). 

 The ETF menu


So all we are left to worry about is covariance - correlation and volatility. Essentially we want pretty much to choose the ETF's with the lowest correlations and offering the best diversification. Given our limited menu that means we won't able to buy ETF's for every country in the Eurozone for example, as they are likely to be quire correlated and that's a waste of our limited number of options.

Initially lets suppose we have £10,000. I want to buy my ETF's with say a minimum of £500 for any one in my theoretical £10K portfolio. It turns out that around eight fairly diversified ETF's will tend to have an allocation of at least 5%. So I will start with the following four Vanguard equity funds (all cheaper than their ishares counterparts):

VEUR FTSE Developed Europe

And these four ishares bond funds:

IGLO ishare global government bonds
SEMB emerging markets $ government bonds
HYLD global high yield corporate bonds
CORP Global corporate bonds

I won't spend too much justifying this selection; particularly with ishares availability of choice we could have chosen a slightly different set of bond funds but it probably won't affect our performance too much.

The hard maths bit

Because some of these ETF's are quite new I've only got about a year of daily price data. This isn't much. Step one is to run a 'point estimate' optimisation of the above just to see what it gives us. I say point estimate because we are going to estimate a single covariance matrix of returns based on all the history we have. This is what people normally do when they do portfolio optimisation. This gives us a very unbalanced portfolio (some would say insane).

  • 0% VUKE FTSE 100 UK
  • 69% VAPX FTSE Asia
  • 0% VEUR FTSE Developed Europe
  • 0% VUSA FTSE S&P500 US
  • 3% SEMB emerging markets $ government bonds
  • 10% IGLO ishare global government bonds
  • 11% CORP Global corporate bonds 
  • 18% HYLD global high yield corporate bonds

Two questions we should ask; firstly am I comfortable with such an extreme portfolio based on only 12 months of data? (Answer for me: No). Secondly is the last year representative enough of likely future history?(Answer: Probably not).

Thinking about the first question; the problem is that by using a point estimate of the covariance matrix I am missing out on the fact that there is a lot of noise in the underlying data. A better method is to use bootstrapping. What we do is randomly select 30 days worth of returns and estimate our portfolio based on those. Note that this destroys any structure of returns through time, if that is important. What is nice about bootstrapping is that with more evidence: more history and the more structure in the data, the more the weights are allowed to deviate. So if the last year is unrepresentative it can't do too much harm.

We then take an average of the bootstrapped portfolios and voila.

The result is much more reasonable:

  • 6% VUKE FTSE 100 UK
  • 28% VAPX FTSE Asia
  • 21% VEUR FTSE Developed Europe
  • 10% VUSA FTSE S&P500 US
  •  7% SEMB emerging markets $ government bonds
  • 8% IGLO ishare global government bonds
  • 10% CORP Global corporate bonds 
  • 10% HYLD global high yield corporate bonds

The 65:35 split in bonds and equities is pretty similar to what you will see in many example portfolios around the internet. However this means that around 78% of the portfolio risk is coming from equities. The higher allocation to Asia and Europe reflects they are more diversifying; the US market has been too correlated to the UK but also to global bonds thanks to QE. If you believe the last year has been unrepresentative in that respect you might want to reallocate a little from other equity markets to the US. This can be done formally using something like Black litterman or shrinkage.

I repeat the process with 6.5% and 7.5% risk targets. The first gives us half our portfolio risk in equities. So its closest to a 'risk parity' portfolio. The second gives us half our weight in equities, but about two thirds in portfolio risk terms. Going higher than 10% risk target is possible; but assumes that the Asian ETF will continue to show more volatility than the others. I wouldn't bet on it, and having more than 80% of my risk allocation in equities seems quite undiversified.

For investors with between £500 and £10K

If you have less than £10K then 6% for one position seems too low for one allocation. You won't do much harm by redistributing the weights a little. For example you could move 1% of the Asia equity allocation to the UK so all the portfolios are 7% at least. More radical surgery, i.e. a minimum of 10% in any position requires a little more effort. Since you will have 40% in bonds with a 10% minimum per position you need to eithier lower your risk target or remove one of the bonds from your portfolio; perhaps SEMB as that has the lowest weight amongst the bonds indicating it isn't very diversifying. The results of this are shown below.

Finally for investors with perhaps £5K or less having all eight or even just seven ETF's is going to result in quite uneconomic allocations. For less than £1500 I would invest just in VWRL, the Vanguard 'All world equity' index. With more than that I would advocate splitting between VWRL and IGLO. Again these portfolios are in the tables below.


Those who only want to know the results; skip to here.

£10K or over to invest: A portfolio with half its expected risk in bonds and half in equities (6.0% expected risk target)

  • 7% VUKE FTSE 100 UK
  • 13% VAPX FTSE Asia
  • 9% VEUR FTSE Developed Europe
  • 6% VUSA FTSE S&P500 US
  • 8% SEMB emerging markets $ government bonds
  • 20% IGLO ishare global government bonds
  • 22% CORP Global corporate bonds 
  • 15% HYLD global high yield corporate bonds



£10K or over to invest:A portfolio with half its funds in bonds and half in equities (7.5% expected risk target)

  • 8% VUKE FTSE 100 UK
  • 20% VAPX FTSE Asia
  • 14% VEUR FTSE Developed Europe
  • 7% VUSA FTSE S&P500 US
  •  8% SEMB emerging markets $ government bonds
  • 15% IGLO ishare global government bonds
  • 16% CORP Global corporate bonds 
  • 12% HYLD global high yield corporate bonds

£10K or over to invest: A portfolio with about the same expected risk as the FTSE 100 (10% expected risk target)

  • 8% VUKE FTSE 100 UK
  • 26% VAPX FTSE Asia
  • 19% VEUR FTSE Developed Europe
  • 10% VUSA FTSE S&P500 US
  •  7% SEMB emerging markets $ government bonds
  • 8% IGLO ishare global government bonds
  • 10% CORP Global corporate bonds 
  • 10% HYLD global high yield corporate bonds


£5K or over to invest: A portfolio with about the same expected risk as the FTSE 100 (10% expected risk target), and at least 10% in each ETF

  • 12% VUKE FTSE 100 UK
  • 25% VAPX FTSE Asia
  • 19% VEUR FTSE Developed Europe
  • 11% VUSA FTSE S&P500 US
  • 12% IGLO ishare global government bonds
  • 11% CORP Global corporate bonds 
  • 10% HYLD global high yield corporate bonds


£1500 to £5K to invest: A portfolio with a bit less expected risk than the FTSE 100

  • 65% in VWRL FTSE All world ETF
  • 35% in IGLO ishare global government bonds


£500 to £1500 to invest: A portfolio with about the same expected risk as the FTSE 100

  • 100% in VWRL FTSE All world ETF

Personally I would be happy holding any of these portfolios for the given risk tolerance. I also wouldn't get anal; feel free to round up or down a couple of % to get nicer and rounder numbers. It won't affect the results in any meaningful way.

It should now take you less than 5 minutes to buy the chosen menu, assuming you have already got a brokerage account. In future posts I will talk about making buy and sell decisions with these portfolios.

Happy investing and good luck!