Category Archives: hedging

Now that’s a property crash

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CNN has a story on house price declines being at their highest in 30 years. Turns out the headline is misleading in two ways. Firstly it proclaims house prices at a 30-year low, which is fortunately not quite the reality. However, the largest decline in 30 years is still pretty shocking. The second item is that the 12.4% decline in US house prices in 2008 is the worst since they have been systematically recorded.

Home prices fell 12.4% during 2008, the largest yearly decline since the National Association of Realtors began keeping comprehensive records in 1979.

As always, averages are a useful measure of overall market movements, but hide some truly enormous declines in individual areas: Continue reading →

Comedy and Tragedy

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What do the names Oneway, Bull, Kansvatter, Inthemoney, The Bull! and Millionaire in the making have in common? They’re all optimistic, aggressive names used in the Make A Million competition. They’re also, as of right now, all in the bottom ten out of nearly 300 entrants and have all lost everything but a few rand from the R10,000 they started with on their chance to Make A Million speculating with Single Stock Futures. None can even take what’s left of their R10,000 and watch a Movie (except maybe at a Sterkinekor Classic, on Tuesdays, in PE).

These aren’t the unlucky few. As I warned in a previous post on how the Make A Million competition is a bad idea and encourages wild speculation and ill-advised risk-taking, the performances of the best and worst entrants is dramatically different after just two months, with rather more entrants looking at poor returns.

The highest return (so far as of about the time this blog is posted) based on the live leaderboard is a massive, impressive return of 735% in two months. That’s over a 30 million percent return on an annualised basis. That is also where the good news ends.

Some more stats:

  • Highest return 735%
  • Average return -27%
  • Median return -53%
  • Worst return -107% (yes, someone lost all their fund and more thanks to the geared danger of SSFs)
  • Approximate percentage of entrants with negative returns 82%

MaM Performance 15 01 2009

It’s abundantly clear that entrants have been massive losers in just a short space of time.  The average return translates to an annual return of -85%. Of course, the position would have looked much better had the markets boomed during the period, and it’s still possible there could be a huge rally from now until the competition ends. It’s just that I wouldn’t give any of my money to Bull! or Spitfire or Druggies or even Fantastic.

Not in a million years.

Ethics, cheating and making a million

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Bodie, Kane and Marcus wrote a wonderful textbook used in finance in universities around the world. I remember reading one of the “boxes” during a lecture at UCT many years ago. It described an ingenious money-making strategy:

Start 16 apparently independent investment advisory newsletters. In the first year, 8 of them forecast gold (or oil, or an individual share) to go up, and 8 of them predict the same security or indicator to fall. At the end of the first year, half of the 16 will have given the correct prediction. The incorrect 8 publications are discontinued.

Out of the 8 remaining, 4 predict a certain (maybe the same) security or indicator to go up, and the other 4 down. At the end of the second year 4 of those will have been right. By this method, at the end of 4 years (or 5 years if we start with 32 publications and so on) we will have a single publication with a perfect track record.

The money-making comes from then selling the next year’s publication at a huge price based on it’s apparent track record.

It’s pure genius, except that it’s illegal (very specifically in the US and clearly fraudulent in general terms in any country I can think of). The strategy may even have a name.

I blogged previous about how the Make a Million competition has, IMHO, dubious merits. However, there is a new twist.

Possibly in response to my concerns around the risk-taking nature of the competition (ok, I doubt this was there motivation, but it’s a nice thought) they describe an alternative strategy that can be implemented to potentially win the competition without taking direct market risk.

The basic strategy involves creating two separate entries (allowed under the rules) and taking opposite positions (using single stock futures) in each account. The individuals total market risk is zero, but if the underlying security does move in either direction, one of the accountants could show a very positive balance and could thus win the competition.

It’s only a small step to consider creating 16 accounts, using half to make major, geared bets in one direction and the other 8 the same bet or “investment” in the opposite direction. Close out the 8 losers and proceed, as above, with the 8 winners. For a reasonably small entrance fee on each of multiple entries, investors can massively increase their chance of gaming the game, without any semblance of investment, trading or even speculative skill.

The winner becomes he most able to manipulate the rules.

FSA bans short-selling

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The Financial Services Authority (FSA) announced that it will ban short-selling of publicly listed stocks until January 16th, 2009 for the UK market where it is the financial regulator. It will then be reviewed.

From The Financial Times:

Hector Sants, chief executive of the FSA, said: “While we still regard short-selling as a legitimate investment technique in normal market conditions, the current extreme circumstances have given rise to disorderly markets. As a result, we have taken this decisive action, after careful consideration, to protect the fundamental integrity and quality of markets and to guard against further instability in the financial sector.�

The articles I read gave contradictory reports as to whether this covered all stocks or just a subset of financial stocks, but it appears that it may just be financials at this point with the possibility of being extended if the FSA feels it necessary. The decision will also be reviewed in 30 days time.

Limiting short-selling sounds pretty extreme to me. Limiting it for such an extended period? I can’t imagine the impact that this will have on hedge fund operators, particularly in the long/short space. Market neutral funds may need to substitute pair trading for shorting the index. (I’m taking a wild guess that shorting the index or at least going short index futures will still be allowed.)

Yes, I think we’ll blame the massive over-extension of credit, with risk concentrations and the careless selling of large amounts of credit default swaps by insurers on the hedge funds. I call scapegoat alert.

The first of many BEE deals drowning

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Moneyweb’s article on Barlow’s re-striking of BEE options echos my earlier post on the trouble of underwater incentive options.

The sense of the article is that this sets a bad precedent. Of course, the precedent has been set years ago – I’ve personally calculated the additional costs under IFRS2 for BEE deals in danger of expiring worthless because the share price didn’t perform as expected. I’ve also seen deals where performance conditions for BEE partners have been massively relaxed because the performance was massively below the original targets.

But more than that, what choice do companies have? I’ll quote my comments on the Moneyweb article below:

Company’s issue the share options in order to improve their black shareholding for BEE purposes. The cost of this was born by shareholders, presumably because the alternative was more costly. (One can argue “right” and “wrong” but here we are talking economics not politics.)

Now, if the options expire out of the money, then the company loses the BEE points. In that case, providing the cost of issuing new options is still less than the cost of not being appropriately BEE rated, then the rational choice is to issue new options. Re-striking existing options is just a pragmatic approach of achieving the same end.

IFRS2, the accounting standard that governs the measurement of the expenses of issuing share options to employees or BEE partners, will require the increase in the value of the options to be expensed. Thus, the economic cost of issuing the options will be recorded in the income statement as well as being a true economic cost.

If the BEE partners had been given shares rather than options, then there would be no chance of them expiring out of the money. They would then experience upside and downside just like ordinary shareholders. However, to achieve the same % black ownership, the expense incurred would have been greater.

The company took a gamble that the share price would rise, hoping to save a buck. Market turned against them, and now they have to dip back into their pockets to pay a little more. Does it make sense for a company to gamble on its own share price? Wouldn’t it be better to take the hit upfront, with no fuzzy option-like liabilities floating around, half-hidden on the balance sheet?

The really frustrating thing is that often the utility cost of the issue options (to the current shareholders) is greater than the utility benefit gained by the BEE partners due to the restrictions on sale and concerns around concentration of risk.

Share options issued by companies for various purposes have many hidden dangers. If you’re planning to use them, it might be worthwhile getting a second or third opinion on:

  1. How to structure it
  2. How much it will cost under a range of scenarios
  3. What impact it will have on the financial statements
  4. How much it will cost to be valued for each financial period as well as audited
  5. Whether it will incentivise the desired behaviour
  6. Whether the beneficiaries understand and appreciate the structure, so that utility discounts are limited
  7. How the costs and benefits of the chosen approach compare against alternatives

Each of these 7 points requires careful thought, experience and training. A little consideration and planning can give dramatically better results.

When you’re underwater, what’s the incentive?

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Employee Share Options became popular during the tech boom of the last millenium. They were used before, but the explosion across more companies, across more levels of employees and as an expected part of executive remuneration was a product of the Silicon Valley boom.

There are pros and cons for share options. Used correctly, they help to align management’s interests with those of shareholders, share profits objectively and allow startup companies to attract heavy hitting staff without needing to reach deep into pockets for cash salaries and bonuses – especially when the cash doesn’t exist yet. The complexities, abuses, high cost, relatively low perceived value, warped risk taking motivations and difficulty in understanding the workings outweigh these benefits in many cases.

A specific problem is that of underwater options. If the share price decline significantly below the original issue price (commonly used as the strike price), the incentives created by the options are changed. Typically, the incentives either:

  • disappear since management isn’t confident of being able to turn the problems around before the options expire; or
  • management take on excessive risk in an attempt to benefit from the upside of successful gambles while being largely protected from failure.

In the case of Old Mutual’s Black Economic Empowerment (BEE) deal, the situation is a little different. Direct managerial control is limited, which reduces the problems of the second point. However, the first point will likely lead to polite requests for sweeter deals, restriking or the issue of additional instruments. All in all not a great deal for shareholders.

If nothing is done, and if the share price continues on its current trajectory, it’s likely the deal could expire without the permanent transfer of ordinary shares to BEE shareholders with grave consequences for Old Mutual’s BEE deal.

I’ve used Old Mutual purely as an example. There are many other companies facing similar problems given the state of the stock market and the higher interest rates (to which notional loans are often linked). I’m also not aware of all the details of Old Mutual’s deals and arrangements.

Airlines and hedging – now there is praise

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Was watching CNN last week, and heard that at least one major US airline, South West, has been making significant use of hedging to manage their fuel costs. Many other US airlines have not been hedging significantly.

Another article mentioned that Lufthansa hedged around 83% of their fuel requirements for this year. Air France-KLM hedged 78%.

Ryanair has gone against a vow not to hedge. Silly thing to vow in the first place.

Typically, the masses aren’t saying what a bad decision it was to hedge given that the oil price has been on the up. Hopefully some will remember this next time airlines hedge and the price drops. It’s not about the outcome, it’s about risk management, focussing on controllable factors and being able to make decisions without the paralysis that huge macro swings can have.

We can’t forefast

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GDP growth below expectations and Standard Bank is likely to miss it’s already previously downwards revised earnings target. We can’t forecast. Our biases, overconfidence, wild anchoring on anything out there, herding instincts so as not to be wrong and obvious about and general inability to understand how little we know about the future are clear.

So if we can’t forecast, and so many of our decisions depend on knowing the future, who are we kididng?