Financial Professionals Summer 2023

This is my quarterly e-mail missive (affectionately dubbed “the massive missive” by one of my readers), intended primarily for my fellow financial professionals. It’s simply a way to share things of possible interest that I have read or thought about this quarter. Enjoy!

First, all over the internet (and in the CPWA study materials) you find variations of: “70% of businesses don’t survive to the next generation” and the quote, “Shirtsleeves to shirtsleeves in three generations.”

It is not correct.

(I like John Quincy Adams’ view: “I am a warrior, so that my son may be a merchant, so that his son may be a poet.” On this formulation, passing the business down would be failure.)

What prompted the comment above was a reference to that statistic (“Unfortunately, only a little more that [sic] 30% of family businesses survive through the second generation”) in a Trusts & Estates article. Notwithstanding that bad stat, the article was a good review of estate tax techniques. Many of us are probably rusty on those since the limit has been so high for a while. Anyway, I found an expanded version of the article for you (and the expanded version does not have that line in it). See pages 19-25 for a good refresher if you would like one. See the whole thing if you would like a primer on selling a private business.

Second, someone commented to me that the level of Elon Musk’s wealth is a new phenomenon and potentially dangerous to society. I replied that I didn’t think it was out of proportion to other historical titans. Anyway, I researched it out of curiosity.

Rockefeller had a net worth of perhaps 1.5% (source) to 2.0% (source) of GDP. Current GDP is $26 trillion (source). 1.5% of that would be $390 billion and 2.0% would be $520 billion. Musk is currently worth about $248 billion (source), so roughly half to two-thirds of John D.

(There are other ways to bring historical figures up to today, but I don’t know how rigorous the methodology is in these various rankings: one, two, three)

Regardless, Musk’s wealth is by no means unprecedented. Also, he is pretty leveraged so if Tesla reverts to a normal auto manufacturer’s PE ratio, I think he gets creamed (source).

Tesla is at 73 PE (and the highest market cap). The next largest auto company (by market cap) is Toyota and their PE is 11 (GM is 6 and Ford doesn’t have positive earnings). It seems reasonable that Tesla perhaps should have a higher PE than those companies, but not that much higher! Anyway, if Tesla was priced by the same multiple as Toyota it would be around 1/6 the value. Musk would get liquidated to cover his debt long before that. Twitter may not be worth much more than the debt on it.

I would not bet on Musk staying at the top of the ranking. (I wouldn’t be against him either, of course, but if I were forced to bet, I would bet his net worth halving over it doubling.)

Two ingredients combine to blow up fortunes: hubris and leverage and Musk is the king of both! (Usually the hubris is the cause of the leverage.)

Third, I don’t know if the numbers are exactly right, but this is absolutely correct conceptually and directionally:

Fourth, one of my consulting clients asked about ETFs vs. mutual funds. Specifically about ETFs in qualified accounts where the tax-efficiency doesn’t matter. I thought my response might be of use to some of you as well:

You are absolutely correct about the gains in non-taxable accounts. But even aside from that, ETFs are superior. Historically there have been more and better choices in funds, but I don’t think that’s true anymore. DFA caving in is a really big indicator that the era of mutual funds is over. I think in the future mutual funds will become obsolete actually.

Here’s a few specific things to think about:

When there is a discrepancy between an ETF price and a fund price it is usually the ETF that is “correct.” In other words, the price discovery is happening in the ETF because (depending on the asset class) the underlying securities may not be trading, or may be trading with wide spreads. But here’s the thing, the ETF manager can’t really make a bad call about the NAV because the creation and redemption baskets (for most funds, there are a few that are “cash settled”) are in-kind. With a mutual fund the manager sets the NAV and cashes people out (or lets them buy in) at that mark. There is an incentive to not mark the NAV down enough when markets are crashing because it just makes the fund look worse and spurs more redemptions – and lowers fees. (I don’t know how big this effect is, but the incentive is there, but it can only really be done with illiquid holdings that aren’t trading, and some of the mismarking might simply be over-optimism.) The ETF has no issue with any of that – they can’t mis-mark the NAV because the market sets the price.

Also, there is friction when something is bought and sold. It’s not a huge friction these days, but it’s there (and worse in crashes as spreads widen). In a mutual fund, the long-term owners of the fund bear the trading costs from the short-term owners buying and selling. With an ETF everyone essentially bears their own trading costs (through the bid-ask spread on the ETF). If you are a long-term investor, you should prefer the ETF; if you are a short-term trader, you should prefer the MF.

Of course, the ETF’s visible expense ratio is generally lower too. Part of that is competition, part of it is that it is cheaper to run an ETF. A mutual fund has to do more accounting and administrative tasks. For example, if I want to buy XYZ ETF at the market and you want to sell XYZ ETF at the market, our trades meet and we transact and the ETF has literally nothing to do with it. But if it is XYZ fund then the fund sells some shares to me and redeems some shares from you and has to account for all that.

Fifth, I saw a good article on efficient markets.

Sixth, is higher education still worth it? Yes, but as noted in this Economist article:

Dropping out without any qualification is an obvious way to make a big loss. Taking longer than usual to graduate also destroys value (because it eats up years that might otherwise have been spent earning full-time). Both these outcomes are common. Across the rich world less than 40% of people studying for undergraduate degrees complete their courses in the expected number of years. About one-quarter still have no qualifications three years after that.

…

Choosing the right subject is crucial to boosting earning power… By far the best-earning degrees in America are in engineering, computer science and business. Negative returns seem especially likely for music and the visual arts.

…

What you study generally matters more than where you do it. That comes with caveats: the worst colleges and universities provide students with little value, whatever they teach. But on average people who enroll in America’s public universities get a better return over their lifetimes than students who go to its more prestigious private non-profit ones …

I’m sure none of that is particularly surprising.

Seventh, the top 1% of folks by income is a lot of business owners (source):

Smith, Yagan, Zidar, and Zwick find that the 1 percent’s income is being driven by owner-managers, mostly of small and medium-sized companies – specifically S corporations, partnerships, and limited liability companies. These are talented managers: the researchers find that profits of companies run by these 1 percent-ers are far higher than those of businesses owned by people in the top 5-10 percent. In the researchers’ sample, when these businesses’ owners died prematurely, while still running their companies, profits plunged by more than half.

The average company in the top 1 percent of income has $7 million in sales and 57 employees, according to the research. “If that firm has, say, a 10 percent profit margin to split between two owners, it’s enough to put someone in the top 1 percent category,” says Zwick. The businesses earning the most profits in the bulk of the top 1 percent were physicians’ and dentists’ offices, professional and technical services, specialty trade contractors, and legal services.

That study is a few years old, but I only recently saw a link to it in something else I was reading. To be in the top 1% of household income today you need to make about $570k (source).

Eighth, our news media focuses on the negative (it leads to more “audience engagement” – i.e. it keeps people watching), but for balance, here is a view from “across the pond” (The Economist is a UK publication). TL;DR: “The world’s biggest economy is leaving its peers ever further in the dust.”

It’s not worse today, but we think it is. Also see this.

I also highly recommend (and have for years) The Rational Optimist: How Prosperity Evolves.

Ninth, there was a query about home warranties on a professional message board. I didn’t respond, but thought I’d put down some thoughts on insurance in general while I was thinking about it.

The expected return on any insurance purchase is usually negative because, on average, insurance companies are profitable and there is overhead as well. For policies such as children’s life insurance, it is almost all overhead cost (see this for more on that topic).

That said, there are four factors that might make purchasing insurance worthwhile anyway:

1. There is a tax benefit (e.g., the death benefit of life insurance, where the insurance is the fixed income portion of the portfolio, which is to be left to heirs)
2. There is some bulk/negotiated discount in prices for the insurance company over what the consumer could get directly (e.g., a lot of health insurance)
3. The exposure is economically large to the consumer and the risk is low (e.g., homeowner’s insurance)
4. You think the insurance company has mis-priced the risk in your case (e.g., group life insurance when the individual has been diagnosed with cancer that is expected to be terminal)

Tenth, some good quotes for my collection:

I should say that it is from time to time the duty of a serious investor to accept the depreciation of his holdings with equanimity and without reproaching himself. – John Maynard Keyes

Money is more like a vaccine than a performance-enhancing drug. It can prevent a lot of misery, but it won’t necessarily make you happier. – Derek Thompson (h/t Morgan Housel)

Eleventh, I learned a few interesting factoids recently:

• There are more CFPs over age 70 than there are under age 30 (source).
• Apple has a bigger market cap than the Russell 2000 (source).
• “[V]isitors to Karl Marx’s grave have to buy tickets, whereas Adam Smith’s grave is free to all.” (source)
• There are more realtors in the country than there are single-family homes available for sale (source).

[I checked that last stat, and it isn’t even close, particularly if you consider “real estate agents” and not just “realtors.” There are over 3 million real estate agents (source) and fewer than 600,000 active listings (source).

Twelfth, I don’t like immediate annuities for retirement income because of the huge inflation risk (there are none available with inflation-adjusted payouts).

I don’t like deferred annuities with lots of bells and whistles. You are really buying options strategies and paying a lot for them.

But, in theory, I do like a plain-vanilla variable annuity for clients who, 1) are in a very high tax bracket, 2) whose fixed income allocation is larger than their tax-advantaged accounts, and 3) if interest rates are high enough, and the marginal cost of the annuity low enough, to make paying for the deferral worth it.

In other words, suppose a client with a $1,000,000 portfolio should have a 60/40 model but the taxable account is $700,000 and the retirement accounts are $300,000. There is $100,000 of fixed income that doesn’t “fit” in the retirement accounts and will be held in the taxable account.

What should we do with that $100,000? Well, there are several things you could do, which I have listed at the end of this.

With interest rates rising, and having talked with an annuity company recently that provides fee-only annuity products on the Schwab platform, I thought it was time to look at variable annuity options for wrapping fixed income.

The product holds the Vanguard Total Bond index and has an additional cost of 45 bps for the annuity wrapper. The yield on BND 4.3% (source).

Given a long enough holding period the annuity will win. The question is how long is that period now? I will make this about as favorable to the annuity as possible. I will assume the client is in the 54.1% marginal tax bracket (that is 37% federal, 3.8% NIIT, plus California’s top rate of 13.3%).

The breakeven is … 13 years! Ok, let’s do a more realistic situation, and assume the client is in Florida (no state taxes). The breakeven becomes 17 years.

Seems compelling – except for the fact that we might do better buying municipal bonds. The YTM is 3.2% on VTEB and 4.3% for BND. The breakeven tax rate is thus 26.6%. So, for marginal brackets above 26.6% we know that VTEB beats BND. Below that BND wins, but would an annuity wrapper on that win in a reasonable time frame? If I change the tax bracket to 26.6% (which I know isn’t a bracket), the breakeven is 30 years.

TL;DR: Munis, not annuities, (at the moment) for clients in high brackets, and taxable bonds without an annuity wrapper, for those in lower brackets.

Thirteenth, related to the previous point, we don’t use state-specific muni funds. The extra cost (and less diversification) generally isn’t worth it. In fact, it usually isn’t even close.

Here’s the math using GA. The cheapest GA fund looks like TBGAX on a quick search, so I’ll use that as an example. The expense ratio is 0.43%. The SEC yield is 3.45%. The expense ratio of VTEB (the fund I use that isn’t state-specific) is 0.06%. So the expense ratio is 37 bps higher. But you save 5.75% (the GA state tax rate) of the 3.45%. We can solve for the yield at which this would break even and it’s 6.4% which is significantly above 3.45%. So, don’t do a state-specific Muni unless we get back to really high interest rates (like the 1970s) or the expense ratios are much closer.

The math is the yield times the tax rate needs to be higher than the difference in expense ratios, so the breakeven would be: YIELD * TAXRATE = ΔEXP. Rearranging to get the YIELD by itself would give us a breakeven at YIELD = ΔEXP/TAXRATE or, in this example, 0.0037/0.0575 = 6.4%. Not a close call – I think people are buying the funds without doing the math!

Fourteenth, the previous research on what percentage of stocks have positive returns (see here) has been expanded (here) to include international stocks. Here’s the abstract:

We study long-run shareholder outcomes for over 64,000 global common stocks during the January 1990 to December 2020 period. We document that the majority, 55.2% of U.S. stocks and 57.4% of non-U.S. stocks, underperform one-month U.S. Treasury bills in terms of compound returns over the full sample. Focusing on aggregate shareholder outcomes, we find that the top-performing 2.4% of firms account for all of the $US [sic] 75.7 trillion in net global stock market wealth creation from 1990 to December 2020. Outside the US, 1.41% of firms account for the $US [sic] 30.7 trillion in net wealth creation.

Related (from this): “If the goal is to construct a portfolio with an R^2 of 0.90, where 90% of the variation could be attributed to the market, we believe a portfolio would need ~75 stocks.” But the chance of missing the big winners is still pretty high because of the extreme skewness in the distribution.

Fifteenth, good advice from an unexpected source here. (FYI, it’s from 1977 – after he was out of office.)

Sixteenth, 36% of folks have more in credit card debt than emergency savings and only 43% would pay a $1,000 unexpected expense from savings (source).

Seventeenth, I think most firms don’t do it right, if by “right” we mean help the client vs. their bottom line, see this. Financial planning is the most useful to clients (IMHO), but it doesn’t scale well so it doesn’t maximize firm profits. It’s the right thing to do though!

(But fortunately there have been at least some professionals fighting the good fight.)

Eighteenth, a few months ago Anitha & I attended the IWI ACE conference in San Diego. I jotted down a few things I liked:

“Estate planning is preparing the assets for the family. Wealth planning is preparing the family for the assets.”

When explaining MCS results to clients, don’t say, “You have a 90% probability of success.” Rather say, “You have a 10% chance of having to adjust your portfolio distributions downward.”

Great longevity calculator here.

From Corey Chiocchetti (but probably not original to him):

“You can never have enough of what you do not need to be happy.”

“There are no shortcuts to anyplace worth going.”

“Money isn’t bad until it defines you.”

Ask your employees, “How is it going? And there are no consequences to telling the truth.”

When you interview someone for a job ask them these two questions:

“Define character for me.” (You are looking for demeanor, body language, and how they think about it, rather than a specific answer.)

“Tell me about some intangible things you accomplished at your last job.” (How did they make it a better place to work?)

(He also had some fundamental errors in his presentation, but you can sometimes find gold in dross.)

The conference is highly recommended, but next year’s is 1) in Vegas, and 2) right at the end of tax season, so we won’t be going.

Nineteenth, I have opined on bucket strategies before, but just had a new (though perhaps obvious) thought on it. If you are using the 4% rule, and you are using the 5-years-of-spending-in-safe-assets bucket strategy (which seems to be the most common version of that strategy), then that is just an 80/20 portfolio allocation. If you have 10 years of spending in safe assets then it’s a 60/40 portfolio. No need to dress it up in buckets!

Twentieth, good article on international diversification from Cliff Asness, et al here.

Twenty-first, a good point about savings rates: “Once you’re saving a lot, saving more doesn’t move the needle.” (source)

Twenty-second, I came across an interesting paper on the gender gap in housing returns. (I didn’t realize there was one.) Here’s the abstract:

Using detailed transactions data across the United States, we find that single women earn 1.5 percentage points lower annualized returns on housing relative to single men. Forty-five percent of the gap is explained by transaction timing and location. The remaining gap arises from a 2% gender difference in execution prices at purchase and sale. Consistent with a negotiation channel, women list for less and experience worse negotiated discounts. The gender gap shrinks in tight markets, where negotiation is replaced by quasi-auctions. Overall, gender differences in housing explain 30% of the gender gap in wealth accumulation for the median household.

Twenty-third, probabilistic thinking is, I would argue, the foundation of quality financial planning and investment management. Here is a good article from Robert Rubin on that. Some key excerpts:

At the heart of my own approach is “probabilistic thinking,” the idea that nothing is 100 percent certain and that everything is therefore a matter of probabilities. Whether my choices would affect a few people or millions of people, my preferred tool for applying probabilistic thinking has always been the same: a simple yellow legal pad. On my yellow pad (or more recently, my iPad), I’ll list possible outcomes in one column, and then my best estimates of the probabilities associated with those outcomes in another.

My goal has never been to quantify every aspect of every decision; that would be impossible. Instead, my yellow pad has become both metaphor and means, a way of applying a questioning mind-set and incorporating probabilistic thinking into the real world. There are, of course, decisions throughout my life that looking back I should have made differently. But the yellow pad has served me well, allowing me to think in disciplined ways about risks, probabilities, costs and benefits, and substantially increasing my odds of making the best possible choice. What’s more, I believe the yellow-pad approach can be beneficial for everyone.

For example, applying probabilistic thinking to real-world events changes the way one thinks about risk. Too often, decision makers trying to anticipate a risk focus on a single potential outcome, or perhaps a small handful of outcomes. Probabilistic thinkers, on the other hand, recognize that risk is a wide range of possibilities.

…

Those who employ a yellow-pad approach and incorporate probabilistic thinking into their decision-making also tend to be more aware of and open to trade-offs. One can and should have principles and priorities. But principles and priorities often conflict, and it is important to have an effective approach to decision-making when they do.

…

Employing the yellow pad also helps one learn the right lessons from the past. Here, the mistake people too often make is to judge a prior decision solely based on the outcome that occurred. Outcomes do matter. But they’re not all that matters.

Twenty-fourth, in our office we talk a lot about the first few of the points made in 31 Lessons I’ve Learned About Money, but there are lots of nuggets throughout.

Twenty-fifth, a paper came out on Equity Tail Protection Strategies. Here is the abstract:

Tail risk is usually an important consideration for investors, and a desire to limit catastrophic loss has led to significant interest in protection strategies. Across four distinct market periods surrounding the COVID pandemic, we explore three common tail-risk mitigation strategies (1) a long volatility protection strategy using options; (2) a put protection strategy and (3) a long VIX futures protection strategy. Our analysis found three main themes emerge. First, hedging is expensive. Second, the variable equity exposure embedded in option strategies is a source of risk and path dependence. Finally, a hedger’s decision on whether to delta-hedge their option exposure to isolate the option convexity, or to maintain an unhedged position, materially impacts performance in non-forecastable ways. We also acknowledge the number of well-reasoned arguments both in favor and against implementing tail-risk hedging strategies. We find that the dispersion of outcomes across only the few strategies explored in this article is notable, and that there is likely no easy solution for tail-risk hedging. Those who implement protection strategies should plan for the possibility that their hedges make things worse in times of stress. (Emphasis mine.)

TL;DR: just own a broadly diversified portfolio. Being clever isn’t particularly helpful – though it may sell better to clients!

Twenty-sixth, recently we’ve run across a few people lately whose finances are a disaster, and there are no good solutions. That’s unusual for us, and it’s troubling.

Anyway, I just ran across a quote that seems to fit what happened to those folks, here’s my version: “You can evade reality, but you cannot evade the consequences of evading reality.”

(That quote is commonly attributed to Ayn Rand but probably not.)

Twenty-seventh, I have long believed that most serious financial planning problems aren’t fixable with financial planning because they are not technical problems; they are behavior problems. (Anitha is much more optimistic – she thinks I’m cynical; I claim I’m experienced.)

For example, when student loan payments were paused, the borrowers could do (roughly) three things at that point with their unexpected free-cash-flow, sorted by most prudent to least prudent:

1. save the money (or pay down other debt),
2. spend it,
3. spend even more by increasing consumer debt so the payments stayed the same.

What do you think folks did?

Well, we now know. Here’s the abstract from a new paper:

We evaluate the effects of the 2020 student debt moratorium that paused payments for student loan borrowers. Using administrative credit panel data, we show that the payment pause led to a sharp drop in student loan payments and delinquencies for borrowers subject to the debt moratorium, as well as an increase in credit scores. We find a large stimulus effect, as borrowers substitute increased private debt for paused public debt. Comparing borrowers whose loans were frozen with borrowers whose loans were not frozen due to differences in whether the government owned the loans, we show that borrowers used the new liquidity to increase borrowing on credit cards, mortgages, and auto loans rather than avoid delinquencies. The effects are concentrated among borrowers without prior delinquencies, who saw no change in credit scores, and we see little effects following student loan forgiveness announcements. The results highlight an important complementarity between liquidity and credit, as liquidity increases the demand for credit even as the supply of credit is fixed. (Emphasis mine.)

You can’t help people who make decisions like that!

Twenty-eighth, more evidence that momentum is 1) pervasive, and 2) caused by investor underreaction, is here. Abstract:

We study equity markets between 1900 and 1925 to provide a pure out-of-sample test of three major asset pricing anomalies: momentum, long-term reversal, and size. We find strong evidence of momentum in almost every market. Momentum is a local phenomenon, as the returns of momentum long-short portfolios have low correlations across markets. We find no evidence of long-term reversals or size effects. In fact, large stocks slightly outperform small stocks in most markets. The presence of momentum, combined with the absence of long-term reversals, indicates that underreaction should be considered as a key aspect of behavioral theories of momentum.

Other key points about this period of time (i.e., YMMV in 2023) from the paper:

1. 7.5% long/short annual alpha (long side contributes more)
2. Uncorrelated across markets (it’s a local phenomenon)
3. No long-term reversals (i.e., short-term underreaction only)
4. No momentum “crashes” (as we had in early 2009)
5. No (or perhaps negative) size premium
6. Negative market beta

Twenty-ninth, I don’t think most people understand how large language models, such as ChatGPT, work. If you want a deep dive into what they are really doing, this piece by Stephan Wolfram is good.

Thirtieth, there is an excellent explanation of covered call writing (with data) here. TL;DR: It’s fairly stupid. (I have covered this before.)

Thirty-first, I ran across a great step-by-step explanation of how to do factor models in Excel here. Or you could just use this site. Much simpler!

Thirty-second, I was talking with someone recently about returns over various time periods and I mentioned the market has negative serial correlation on a daily basis, but the effect is very small – not big enough to overcome transaction costs. I realized I had only read that years ago and hadn’t checked it myself (that I recall anyway; knowing me I probably did but have forgotten).

I was also curious if the close-to-close was different from the open-to-close. I don’t have opening values on the S&P 500 until April 20, 1982 so I will use data from that point.

From the previous day, the close-to-close daily serial correlation is -6.1% and the open-to-close is -4.1%. So, yes, there is a very small negative serial correlation on daily returns.

Thirty-third, I talked about REITs a while ago (here), but I just saw this and thought it was good (source, I corrected the punctuation and spelling though, that part was bad):

The first time I saw BREIT’s eye-popping, logic-defying, performance I immediately took it to a quant shop famous for statistical replication. But I didn’t tell them what it was. Just “can you replicate this return stream?”

I was expecting a long response with charts and graphs and implements of destruction. All I got back was this: “ha ha ha”

So I called. “I’m sorry, but I don’t get it. What do you mean?”

“That was a joke, right, Phil? This is just leveraged Treasurys.”

“No, it’s BREIT. Can you replicate it?”

“Sure. Leveraged Treasurys.”

Thirty-fourth, I would be remiss if I didn’t pause to recognize the passing of Harry Markowitz, Nobel Prize Winner and Father of Modern Portfolio Theory. He has been eulogized many places (NYT for example), but I liked John Rekenthaler’s take (here).

His seminal paper can be found here. Everyone talks about it, but few today have read it. It’s only 15 pages – if you are an investment professional, you should read it. Contrary to modern depictions of his theory, the efficient frontier graph has the axes switched and the measure of risk is variance rather than standard deviation (the square root of the variance), but that doesn’t affect the conclusions. You also may be interested in his 1959 book, Portfolio Selection.

I’ll let Harry close:

A good portfolio is more than a long list of good stocks and bonds. It is a balanced whole, providing the investor with protections and opportunities with respect to a wide range of contingencies. – Harry Markowitz

Finally, my recurring reminders:

J.P. Morgan’s updated Guide to the Markets for this quarter is out and filled with great data as usual.

Morgan Housel and Larry Swedroe continue to publish valuable wisdom. Just a reminder to go to those links and read whatever catches your fancy since last quarter.

That’s it for this quarter. I hope some of the above was beneficial.

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