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Peter F. Way, Blockdesk (702 clicks)
ETF investing, CFA, portfolio strategy, long/short equity
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The answer for most investors, even those without any special advantages, is that your precious TIME investment gets far more productively employed that way. Our earlier article makes it clear why that is so, and is worth re-reading. Lots of words have gone over the dam since then, but here are the high points:

  1. Your investment objective likely has a, or some, date deadline(s). A prolonged Buy, Hold & Forget (BH&F) error can disastrously waste time that may never be recoverable.
  2. Most available, spendable investment returns in these government-controlled, yield-crushed, times will come from capital appreciation rather than from interest "rent" insults to your capital.
  3. High uncertainty times like the present cause wide fluctuations in equity prices (including ETFs of all types), creating sizable proportions of their investable time spent in decline. A BH&F single-date commitment of capital runs the risk of poor entry timing choice and denies the capture of good exit choices. Instead, multiple entry commitments using actively-realized capital gains can compound the profits of previous astute investment choices in fresh investment instruments at opportune acquisition points in time, working the same capital over and over.
  4. Bad choices in condition #3 above will compound one's grief in the wealth-building or spendable-income generating process. That can come about either by investing in things that do not pay-out from the start (where forfeited time hurts, along with expected capital-gain deficiency or loss) or by multiplying mistakes in judgment.

Since conditions 1) and 2) cannot be avoided, condition 3) demands a best-efforts action to avoid condition 4).

There are many recommended approaches to advance the desired outcomes in 3. But few, if any, of them come from Buy, Hold & (particularly) Forget. The most widely-practiced alternative approach is the techno-socio-economic-political study of past history and recent trends, to make useful predictions of future stock price events.

True current story: A pastor, in that regularly-scheduled part of his Sunday service known as "the children's message" asked the dozen or so kids who came forth to participate, "Who knows what a prediction is?" One five-year-old quickly raised his hand and answered: "A good guess!"

Out of the mouths of babes. It took the congregation several minutes to stop applauding, laughing and cheering.

How are your guesses? Do you make a living at it? Where do you get your information? How often is it updated? When did you last check on your sources' past accuracies? Do you have any team help in assembling the information or evaluating its probable implications? What do you have to lose if your decisions are wrong? How many wrong ones mean a personal catastrophe?

Learning how to compete

Few of us are so specially endowed that we can't use a bit of help in evaluating complex, constantly changing situations in a serious game environment where what is at risk is one's investment capital. This isn't just local bragging rights over whose high-school football team wins the Friday-night game. This game is multi-year, generations-transcending in its accomplishment. We all need to do as well as possible, in the face of similar efforts by other equally-determined combatants. Help usually is needed and can be very valuable.

So, don't send in the clowns. Better to call on street-savvy widely-experienced professionals whose most convincing credentials are their continuing employment at annual compensations in multimillion-dollar amounts, despite the ambitions of newer young tigers eager to take their places.

This is the story we have told many times in these articles. But the situation recalls a favorite Quaker college professor who told me that his most effective teaching tool was that of "repetitive concussion." So here is the lesson once again:

Nearly everyone seeks to improve his/her personal situation, if not directly for self, then to the benefit of family or perhaps important close friends. This investing business to build wealth that can be put to the task is a serious, in many cases, a crucial life-changing GAME. What makes it a game is that every accomplishment requires the actions of other players in the game. Every buyer needs a seller, every seller needs a buyer.

There are no immutable rules in investing. Gravity does not exist. No rules of thermodynamics or of motion can be relied upon. Sodium bathed in chlorine may produce salt, but stocks bathed in accounting earnings (either bigger or smaller) may not produce higher (or lower) prices.

It all depends on what the other "poker players at the table" decide to do, NOW. That depends on what their thinking is NOW, not necessarily what they used to think under different circumstances. This game is not one of applying the "hard" sciences, but of dealing in the "soft" social sciences.

We all can learn from the first-place game that makes this one the second-most serious game: War.

There, a first rule is "know your enemy". In our case, they are the other players in the game that have the strength to move market prices. That tends not to be individual investors, but instead are the big-money funds that aggregate capital from many sources, including from us individuals.

They have the financial resources to build their own internal intelligence systems to keep themselves informed on what other players in the game are likely to expect of various investments. To augment those systems they attempt to learn what they can from the helpers they must hire to get done the transactions that will favorably position the capital under their control.

Those helpers are the market-makers [MMs]. The big-fund organizations have a big limitation, their bigness. When trying to shift billions (in some cases trillions) of dollars worth of capital from one formerly-favored investment security into another, the game constraint comes into play: The other side of the trade [OSOTT].

What market-makers do

The MMs' job is to assemble enough buyers for the issue BigFund is moving out of, and sellers of the issue BF now favors, to get both trades done. Since the BF positions involved are often many times the number of shares traded daily, that is not an easy task. And since the persistent presence of a volume buyer or a volume seller day after day in any issue will usually move its price in an unfavorable direction, simply breaking the big lump down into smaller pieces often will not do the job. It could take months, not hours.

Long ago the MMs learned that they needed to "defend themselves at all times" even from (especially from) their clients, who might know of suddenly changing circumstances that are likely to move securities prices. So the MMs invest heavily in maintaining and expanding world-wide information-gathering systems that employ state-of-the-technology capabilities to keep themselves informed. Their intent is to stay a step ahead of ALL other players in the game, where possible.

In addition, "ya gotta know the territory, the territory, the territory" so the MMs keep a thorough book on who owns what. There are info services that comb public (and other) sources to help them do that. Then, in the course of doing everyday business with these clients, the MMs develop personal relationships and familiarity with the fund trade desk pros who are on the other end of their phone lines dozens of times a day.

Everyone keeps their guard up, but to get done what trades need to be "filled," each mystery can be carried only so far. The "rules" of the MM game are that the client's identity, urgency, and specific size of the desired trade are never to be revealed in assembling the OSOTT. But "easy", "determined", and "desperate", are words sometimes heard, along with "normal", "large", or "huge" as they talk with their counterparts at other MM firms. The word gets around, since it typically is other BigFund clients on the hunt for opportunities, which can quickly make up all of the OSOTT. And thousands of such trades occur, worldwide, each day. No time to waste.

In some large proportion of the "block trades" with volumes of thousands of shares (sometimes millions) it is virtually impossible to collect an OSOTT within the price and time limitations set by the BigFund trade order originator client. One way to avoid having to "kill" the order is for the MM firm itself to take the "stub" end of the trade order that can't otherwise be filled, onto its own books, using its own firm capital.

When that is done (typically in some 90% of block trades), the MM now has a capital risk exposure not otherwise encountered. So one of the other special resources developed over the centuries within MM firms is an actively-advanced skill in the art of hedging. That skill of structuring counter-balancing positions in related (often derivative) securities is utilized in protecting the firm's capital.

What keeps this complexity in the game honest is that, like in the foundation game of investment securities transactions, there needs to be both buyers and sellers of the hedging securities. Hedging, like insurance, involves the transfer of risk between parties, for a price. So the block-trade buyers of price-change insurance need sellers.

They are typically found in firms who also have well developed skills at the enterprise, and are well informed about the potential risks involved. That's right, other MM firms, at a part of the house known as the "proprietary trading desk." There, money is made for the firm by taking on price-change risks for an appropriate (profitable) price.

Our insights into the MM community's price range expectations come from the way the hedges are structured, and the prices being paid for the coverages involved.

Temptations are a human failing, and since MM organizations are staffed by and run by humans, there are often opportunities for the MMs themselves to do what all the other players in the game are trying to do. Since the nature of the game drives the MMs to try to know as much as (or more than) all the other players, there needs to be some set of acceptable rules to keep the game within bounds that will not discourage other players and thus destroy the game. And some disciplinary force to enforce the rules.

In the bulk of the 20th century, the disciplinarians were the exchanges themselves. The laws were written to establish the exchanges as self-regulatory-organizations [SROs]. They were privately owned, not-for-profit organizations. Appreciation in membership shares provided for the accumulations of wealth by members. Those shares were infrequently traded in closely controlled circles by a limited number of knowledgeable, active professionals. Being in the club was the real privilege having value, which was ultimately reflected in the membership "seat" prices.

The advances of information technology ultimately spoiled that discipline structure. The exchanges could, and did, put virtually any "bad-actor" out of business by barring them from the use of the exchange to accomplish transactions. The introduction of NASDAQ seriously weakened that control, coupled with the growth of big-money funds needing big-volume trades filled.

Specialist firms at the exchanges had some exceptional rules treatment in the course of their charge to "maintain an orderly market" (meaning small-price-step continuity between trades), but the size of many block trades became beyond the capacity of their capital resources, however augmented. Their efforts to compete by having "upstairs trading desks" were not successful with other major member firms having far greater capital access.

What eventually transpired was a competition among market-makers that favored those that became publicly traded themselves, known as the "bulge-bracket brokers" who had access to public bond-market financing and other lending capacities. They ultimately displaced the specialists as being the effective volume market-makers.

Then the exchanges themselves caught the competitive contagion, had their own initial public offerings [IPOs] and became publicly traded. As such they were not "not-for-profit" entities, and much of the market disciplines built on being SROs went out the window. A competitive business organization cannot serve two masters, particularly ones that often conflict with one another.

The original laws set up to provide regulations under the Securities Regulation Act(s) of the 1930s created the Securities & Exchange Commission [SEC], but it was perpetually starved of resources by DC politics and in the 20th century was populated only by a shadow force of largely neophyte lawyers looking to establish personal subsequent connections in the investment and banking community. As horribly demonstrated by the Madoff fraud incident, it was totally incapable of providing the originally intended public's protection.

Since then the SEC has attempted a public-relations-oriented activity apparently intended to give the impression of more capable intentions and capacities on its part, but most evident have been the same kind of grossly-after-the-fact public display of what bad things already had been done, rather than any strong deterrent evidence of jail-time punishment of perpetrators caught in the act. There may be improvement developing on that front, but SEC impact as a deterrent seems far from fearful.

A few occasions have occurred where certain exchanges have flagged the fraudulent current behavior of miscreants and prevented situations from becoming worse. That often was how the SEC learned of the problem.

In the past few years there have been major MM firms admitting to being more driven by their own profit interest than those of their customers. Others have been less forthcoming. The regulatory picture remains dangerously weak.

End of history lesson. What matters is how best to play the game.

Using these insights

Conventional practice has been to believe that shorter-term stock price fluctuation (noise) evens out over time and cannot be predicted, so the only sensible and conservative way to invest is to find longer-term trends likely to persist, get aboard at any point, and ride them to profitable progress.

That may have been a competitive approach in the last century, but things have evolved significantly since. Two big differences are 1) interim price fluctuations tend to be larger than they used to be, and 2) longer-term trends now are more uncertain than they used to be, and develop more quickly, due to more radical advances in technology and in competitive practices.

Further, we can now demonstrate abilities to identify odds-on gain opportunities in shorter-term price swings by evaluating the self-protective actions of the MM community. To illustrate that ability, here is a tabulation of how prices of a particular set of over two dozen ETFs have progressed following the forecasts implied by MM actions.

Price forecasting evidences

The table covers the 4+ years from June 2009 to present, and includes day-by-day starts of subsequent market price change experiences in the next 16 columnar weekly (5 market day) intervals for all of the ETFs, for over 34,000 nearly 4-month passages.

Each starting day has a forecast price range with a balance between its upside and downside prospects, depending on where the contemporary market price lay between the high and low extremes of the forecast. We calibrate that balance by finding what percent of the forecast range lies below the then market price, and refer to it as the Range Index.

For example, a price range forecast from a low of 30 to a high of 50, with a current price of 35 would have 5 points of its 20 range below 35, so its Range Index would be 25. The upside-to-downside (reward to risk) balance would be 3 : 1.

Rows of the table are arranged from lowest RIs (negative to +1) and from highest RIs (100 and over) at the table's top and bottom extremes, cumulatively to the mid-range level blue line where the totals of all the data is averaged for each column. Upside-heavy RI rows are noted in green, downside-heavy ones in red.

(click to enlarge)

The data in the columns whose holding periods are yellow-footnoted is in terms of annual rates of change from the start of each experience date, the date of the Range Index that determined its row position. The blue average row shows that these ETFs as a group have had a fairly steady 20-22% per year rate of gain through the 4+ years.

The larger-upside-prospect, lower Range Index experiences, over 600 of them, have been at rates of gain at least double that rate in periods up through 3 months (65 days). And virtually all experiences in the lower half of the table have fallen below the group's average.

Conclusions

Clearly, the MMs have a good fix on the probable future price movements in this set of ETFs. In other ETFs the differences may not be as dramatic, but the presence of advantage is still there.

By teaming up these future price prospects with time-efficient position management disciplines, the compounding of odds-on gains multiple times in a year can and does magnify portfolio returns for active management several-fold over buy, hold & forget.

In another article we will review the advantages of time-efficient risk management principles at the portfolio level.

Source: Why Active Investing Beats Buy, Hold (And Forget) 3-4 Times Over