Category Archives: alternative investments

Doesn’t have two Bitcoins to rub together

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Prediction:  Bitcoins will be irrelevant by 2013 and will never emerge from a very small niche market.

In fact, they are already irrelevant today. This is what happens when open source supporters, crypto experts and privacy nuts think an understanding of C++ and maths equates to knowledge of economics and monetary systems. Oh, and add in an unhealthy dose of paranoia and persecution complexes.

The technology and theory is interesting – bitcoins are effectively a peer-to-peer currency with various controls around their creation, existence, trading and (lack of) tracking.

From a monetary system perspective they are irrelevant. To show the extent of the problem, just read this nonsense article “explaining” why Bitcoins will always have value. The article includes how the “Federal Reserve rescued the dollar in 2008″. I must have missed that. Anytime supporters of a particular idea have completely incoherent arguments for it, that’s a pretty good sign there are no coherent arguments for it.

The author also states as a fact that a South African mobile operator is integrating Bitcoin support.

Prediction: None of MTN, Cell C or Vodacom will ever officially support Bitcoin.

I can’t begin to explain how many different ways this is a bad idea.  Good news is several people already have. Much of the hype about Bitcoins and other cryptocurrencies stems from a lack of appreciation for the devastating impact of deflation, misunderstanding of what the money supply really is and the role of the Federal Reserve in this crisis and the Great Depression.

Now I just need to find a way to short Bitcoins.

The Alpha and Inflation of Commodities

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Commodity prices rise and the world screams hyperinflation.

Elsewhere, alternative investment managers espouse the virtues of commodities as an asset class that generates “alpha” returns (i.e. returns not related to the overall direction of markets). The thing is, it’s hard to have it both ways.  The link between unexpected/expected inflation and equity prices in the short- and long-run is complicated.  High inflation grows earnings in nominal terms, which should grow equity prices in nominal terms. High inflation often leads to higher interest rates and a reduction in money supply through decisions by central banks to put a break on inflation. These higher interest rates stifle the economy and can lead to decreases in earnings, which will give rise to lower share prices ceteris paribus. Built-in inflation expectations where monetary policy is fairly predictable will probably give rise to high nominal equity market returns (but probably not high real returns as inflation has a frictional cost on the economy which often surpasses any gains from real wage declines.)

So if commodity inflation was linked to core price inflation, we would expect a much stronger link between commodities and equities. (Yes, there are a million more points to consider here and not all support this hypothesis.) (Also, obviously as an input into broad measures such as consumer price inflation commodity prices increase that measure, but the point is there is limited knock-on effect on other prices, so core inflation which typically excludes volatile energy and food prices is hardly moved. It’s core inflation that is a strongly autoregressive time series.)

But better than all that, the smarter, better education (and certainly more focussed) people at the Chicago Fed had put together a pretty compelling research paper on commodity prices and inflation (pdf). Check it out.

Commodity prices rise and the world screams hyperinflation. Of course they’re wrong.

Your ERP estimate is still too high

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I recently had a conversation with a colleague who had been told that “Credit Suisse recommended an Equity Risk Premium of 7%”.  I’m curious to know whether they truly view that as an appropriate ERP.  If your ERP is 7%, it’s still too high.

The authors of Triumph of the Optimists have joined forces with Credit Suisse to publish the Credit Suisse Global Investment Returns Yearbook 2010 (pdf) which is a brief update of their brilliant research.  You should definitely read the original book.

The updated research shows a very familiar picture to that of the book.  Here are a few important outcomes:

  • Realised excess returns of equities over bonds have been negative for most countries for the last decade.

Clearly, using realised excess returns (or historical ERPs) over a short period as a measure of future ERP is a bad idea.  I’m fairly sure the future ERP is positive.

  • For the World, the US, the UK, Australia, Belgium, Canada, Denmark, France, Germany, Ireland and South Africa (a few countries I chose to look at before I realised the trend is near-universal) have had declining historical ERPs over the last 110 years. Some have had a few bumps in between, but the overwhelming trend has been downward.  The last decade’s poor performance has obviously helped establish this trend, but it was pretty well established for most of these countries even without the last decade.

Using unadjusted historical ERPs over long periods is a dangerous idea because trends in the data make it a poor estimate of future experience.

  • Over the last 110 years, the average realised ERP in the World has been 3.7% (over bonds). Continue reading →

Fixed Interest is a viable asset class

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I heard someone talking on Classic Business tonight. Pity I didn’t catch his name so I can avoid his advice in future.

He was saying that he doesn’t see the point in investing in debt instruments.  He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.

Well, he’s wrong.

Risk and asset-liability matching

Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities.  Naively consdering expected return only and not asset-liability risks  gives naive results.

Credit risk premia more than compensate for default experience over time

It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.

The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent.  The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.

I’m going to hunt round for some references here so you’re not just trusting my word.

Illiquidity premia = higher returns for some

Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss.  You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.

Pension funds don’t have enough junk

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Junk Bonds are debt instruments issued by corporates that have relatively low credit ratings.  They pay interest at high rates as a result.

Typically viewed as risky investments, the junk bonds boom of the 80s showed that there is more to junk than just a risky investment.

Locally, our pension funds and other retirement savings money should be more heavily invested in junk bonds. I’m surprised more people aren’t talking about this. It might be due to the limited availability of junk in the SA market. On the other hand, if demand picked up, I’m sure we could see more original-issue junk bonds as yields drop and become more attractive financing vehicles.

There are always marks for considering tax

Why should pension funds be invested in junk? Tax. Approved retirement savings vehicles in South Africa don’t pay income tax. Thus, the value of securities that would attract significant tax is higher for these investors than for the market as a whole. If risk and return are balanced for the market as a whole, the extra return available to retirement vehicles through not paying tax is a bonus over and above that appropriate for the risk.

Conversely, pension funds should stay far away from tax-efficient instruments such as preference shares. The prices of these instruments have already been bid up by tax-paying investors. Continue reading →

How not to lose money in Make a Million

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I have a clear strategy for how not to lose money playing the Make a Million competition. As I explain it, you may come up with some smart tactics to win the competition and enhance your returns, but you’re on you’re own there.

So, how does one not lose money with the Make a Million competition?

Don’t enter.


You are overwhelmingly like to lose money if you enter this competition. I’ve said this before, and I’ve been right before. I’m right again.

There’s also the little idea that the  structure of the Make a Million competition increases risks of  financial meltdown

Let’s look at some hard statistics to show what I mean.

Telling statistics (what they don’t show)

In the MaM presentation, the organisers include some interesting statistics about number of trades, trading activity and many other metrics.

They don’t show average returns or performance.

So let’s look at some of the numbers:

Raw return data (excluding prize money) based on 2009 MaM competition.

Average Return -11.49%
Expected Loss R 1,149
Median Return -15.06%
Mode Return -9.12%
Probability of breaking even 25.00%
Probability of earning less than 10% 83.00%
Probability of doubling money 1.78%
Probability of winning 0.20%

Suddenly the competition doesn’t look so great, does it?  (This isn’t the first time, here is my analysis of the Comedy and Tragedy that was the 2008 Make a Million competition.) Continue reading →

Rare monopolies

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China is the overwhelmingly major supplier of rare earth minerals to the rest of the world. (South Africa has a tiny share.)

Rare earth minerals (or elements) are critical factors of production of many high technology items such as super-conductors, catalysts, rare earth magnets and batteries of the kind used in hybrids and laptops.

With that background, you can imagine what a problem it is when China unofficially halts export of rare earth minerals to Japan over a disputed arrest of fisherman. Now, after the US has begun to investigate Chinese trade practices, China has unofficially halted exports of these crucial resources to the US as well.