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“Danger lurked in their very Smiles.” - Capt. Charles Johnson, writing about ‘Pyrates’ circa 1724

Like many others, I read recently that an assistant to Michael Crichton discovered a completed, but previously unknown manuscript for a historical novel about pirates secreted on the hard drive of the late author’s personal computer.

My first thought was “Wow, pirates!”

On reflection, I thought what an astonishing treasure this wonderfully thorough assistant had unearthed, and that it might be fun to do some pirate research of my own, since at the time the Crichton novel wasn’t yet released.

One of my favorite discoveries from that research was Peter T. Leeson’s The Invisible Hook: The Hidden Economics of Pirates (Princeton University Press: 2009).

Leeson is the BB&T Professor for the Study of Capitalism in the Economics Department of George Mason University, and a self-professed lifelong aficionado of the golden age of pirates.

And he expresses no doubt that his two passions intersect. Like Adam Smith’s “invisible hand,” Leeson asserts that an omnipresent “invisible hook” of rational choice economics directed pirates’ every move.

Here he is (emphasis in original):

“It’s not just that economics can be applied to pirates. Rational choice is the only way to truly understand flamboyant, bizarre and downright shocking pirate practices. Why, for example, did pirates fly flags with skulls and crossbones? Why did they brutally torture some captives? How were pirates successful? . . . The answers to these questions lie in the hidden economics of pirates, which only the rational choice framework can explain.”

Whew! And you probably thought pirates were just crazy seafaring thieves.

Not exactly, as Leeson’s well-documented and very readable book attests. And his book covers pirates from bow to stern. In addition to some descriptions of high seas navigation, maneuvers and stealth that border on high adventure, Leeson supplies plenty of counterintuitive, even surprising revelations about pirates, such as their “one pirate, one vote” method of democracy; written constitutions and articles called “pirate codes” that governed nearly every aspect of their behavior; and their wild approaches to “brand building,” which they used to reduce violent resistance to their plundering. And Leeson explains it all with economics.

For instance, historical documents leave no doubt that pirates practiced a nearly pure form of democracy, including electing the top officers serving aboard their ships, as well as voting on seemingly everything else, including their detailed “codes” of behavior.

Here’s an example, which Lesson quotes from an actual pirate document, complete with strange spelling and capitalization:

“The Lights and Candles are to be put out at eight a-Clock at Night. If any of the Crew, after that Hour, still remain enclined for Drinking, they were to do it on the open Deck.”

What kind of pirate crew votes for ‘last call’ at 8pm? The kind that is economically motivated to be fully rested and ready to rob the next morning.

And what could make them employ terrifying methods specifically designed to reduce violent conflict during their robberies? Economics. Fierce battles brought high costs that ultimately reduced pirates’ time and effectiveness “on the Account,” the charmingly businesslike term they used to describe their vocation.

A couple of fair warnings: Leeson’s descriptions of pirate torture methods, also backed up by historical documents, are definitely not for the squeamish. But neither are they gratuitous, as Leeson shows quite convincingly the “hidden economics” behind pirates’ selective use of these tortures. On the other hand, there seems little point to his brief but strange reflections on pirates’ sexual predispositions, and I mention both these cautions in case anyone is thinking the book might be a perfect holiday gift to pique little Timmy’s interest in economics. Think again. Leeson sails past PG-13 in the first 20 pages.

There’s plenty more to the book, including a neat recounting of the details, meanings and origins of the various flags pirates used (the basic “Jolly Roger” skull and crossbones was just one of them); a look at pirate compensation and bonus practices that would make even pay czar Kenneth Feinberg flash a toothy grin; a few pithy pirate management tips; hundreds of historical reference notes; and more.

Bottom line: Peter T. Leeson’s The Invisible Hook is an insightful hoot, and scores a couple of extra points for originality. Economics-minded readers who enjoy historical adventure or relish over-the-top ‘freakonomics’ should get a hearty yo-ho-ho out of this book. Not to mention a 360-degree brain twist before diving into that new Michael Crichton novel.

Amazon link:

http://www.amazon.com/Invisible-Hook-Hidden-Economics-Pirates/dp/0691137471/ref=sr_1_1?ie=UTF8&s=books&qid=1259641855&sr=1-1

Disclosure: No financial interests or relationships.

Isn’t it sad when a beautiful theory gets utterly destroyed by an ugly fact?

That seems to be what happened to a Smartmoney magazine analysis of the performance differences between the iShares S&P SmallCap 600 ETF (IJR) and the iShares Russell 2000 ETF (IWM), which both track popular small stock indexes.

According to SmartMoney, over the past nine years the S&P 600 Index cranked out 56% in capital appreciation, compared to 23% for the Russell 2000, the standard measure of small stocks for big institutions. SmartMoney adds that since 1994, the S&P index has outperformed its Russell counterpart by two percentage points a year.

And true to form, the S&P 600 IJR is whupping the Russell 2000 IWM by a whopping margin since these ETFs’ inception in 2000, with average annual total returns of 6.2% vs. 3.9%.

Truly beautiful, and here’s the beautiful theory:

The S&P 600 Index uses screens, including a profitability screen, to gather up “some of the best companies” in the smallcap universe, while the Russell 2000 does nothing of the kind.

A little bit of digging, along with some rational faith in the stocks of fundamentally sound companies, showed this beautiful theory could be the real thing, because there’s not big overlap in the stocks these two ETFs hold.

Specifically, none of Top 10 holdings of IJR and IWM overlap according to iShares, and only two of the Top 25 overlap, according to the last available Morningstar data.

This, even though the Top 5 sectors for both ETFs are the same, albeit in slightly different order: financials, technology, industrials, consumer discretionary and healthcare.

Both ETFs fit snugly into Morningstar’s “Small Blend” style box, with average market caps of $700 to $800 million. Both show P/E ratios in the mid-20s and betas around 1.3. And both trade near the NAV of their underlying holdings. The difference in their expense ratios is negligible, .20% for IJR and .24% for IWM, all based on iShares data.

Additionally, both have paid a small distribution every quarter since their 2000 inception, with indicated yields of about 1.5%.

So the biggest difference between these two ETFs seems to be their stocks, and the S&P 600 IJR is screening for high quality businesses.

Beautiful. But here’s the ugly fact.

Beginning in the middle of 2007, Russell changed its method for annually reconstituting its index. The change in method was specifically designed to prevent traders from continuing to exploit Russell’s annual index changes with short-term arbitrage strategies.

And since that change in the middle of 2007, IWM and IJR have performed almost identically. Chart their prices at bigcharts.com and you won’t see a millimeter of daylight between them over this time period.

One lesson for investors? Forget the history archives, either of these ETFs could work for your portfolio. Investors who want to stay in step with institutions’ grand view of smallcaps might prefer IWM, while independent-minded believers in fundamental analysis might lean to IJR, but the days of a one-way no-brainer are gone.

Beautiful theories and ugly facts aside, smallcaps can be an attractive spot for a good low-cost ETF, even for investors who like to pick individual stocks. Let’s face it, individual smallcaps can be jumpier than a monkey at lunchtime while many, though not all, small-stock mutual funds stick investors with high expense ratios and hidden trading costs.

And in addition to the small stock indexes, there are ETFs for growth, value, dividend-paying and international smallcaps, as a recent Barron’s article pointed out. Of course, investors with a stomach for rollercoaster rides can find individual stocks in all these areas as well.

Some investors might ask whether the time for small stocks has passed, arguing smallcaps already made their traditional post-bottom move. I’m not artful enough a timer to weigh-in on that one, so will only say that holding smallcaps as part of a diversified portfolio has generally rewarded long-term investors.

By the way, the demolition of this beautiful theory about IJR doesn’t shake my faith about investing in the stocks of companies with strong businesses. Not in the least.

After all, when you compare ETF portfolios of 600 and 2000 stocks that have similar market caps, sector mixes, P/E ratios, dividend yields, style boxes, and on and on – it should be no surprise if you get similar performance.

And so there’s one more lesson here for investors, as well as for investment writers.

Don’t limit your homework to reviewing ancient history. The ugly fact is that things change.

For a look at a stellar ETF (VIG) that shows the value of investing in good businesses that increase their dividends, see my Seeking Alpha article, “Stocks That Raise Dividends Outperform.” For more ETF musings see “Corporate Bond ETFs: Priced for Perfect Convenience?” (LQD, JNK, CSJ).

References and Links

SmartMoney, “Mind the Gap: Similar ETFs, Different Returns,” September 28, 2009. http://www.smartmoney.com/Investing/ETFs/Mind-the-Gap-Similar-ETFs-Different-Returns/?afl=yahoo

iShares, Fund Overview, 2009. http://us.ishares.com/product_info/fund/overview/IJR.htm

Investment News, “Slim Pickings for Russell 2000 Arbitrageurs,” May 29, 2007. http://www.investmentnews.com/article/20070529/FREE/70529008

Barron’s, “Small Stocks, Big Gains,” November 28, 2009. http://online.barrons.com/article/SB125573782557591191.html

Seeking Alpha, “Stocks That Raise Dividends Outperform,” September 23, 2009. http://seekingalpha.com/article/162871-stocks-that-raise-dividends-outperform

Seeking Alpha, “Corporate Bond ETFs: Priced for Perfect Convenience?” October 7, 2009. http://seekingalpha.com/article/165244-corporate-bond-etfs-priced-for-perfect-convenience

Disclosure: Long individual stocks that may be included in these ETFs.

In November 1982 the unemployment rate hit a peak of 10.8%.  Stocks rose 20% over the next 12 months.

 This time? Follow the link to my Seeking Alpha article: “This Market to Workers: ‘Welcome to the Jungle’” published September 21.

And for even more links and analyses, follow the links to my Instablog posts below.

Seeking Alpha, “This Market to Workers: 'Welcome to the Jungle'” http://seekingalpha.com/article/162435-this-market-to-workers-welcome-to-the-jungle

“High Unemployment for Years. Do Stocks Care?” http://seekingalpha.com/instablog/470613-low-sweat-investing/35920-high-unemployment-for-years-do-stocks-care

“The Job Market According to Darwin” http://seekingalpha.com/instablog/470613-low-sweat-investing/30056-the-job-market-according-to-darwin

“Job Market: Darwin Returns,” http://seekingalpha.com/instablog/470613-low-sweat-investing/33746-job-market-darwin-returns