My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Summer 2019

ESG investing (avoiding investments with “bad” Environmental, Social, or Governance aspects) is becoming more popular but has been around a long time. The approach was previously known as SRI (Socially Responsible Investing) or colloquially as avoiding “sin stocks”.

A quick note on terminology first. If I talk about a “good” or “bad” investment, it isn’t clear whether I mean in the moral sense or in the risk-adjusted-return sense, so I am going to use good/bad to refer to the expected risk-adjusted returns and virtuous/evil to refer to moral qualities. I’m also going to avoid scare quotes even though in many (perhaps most) cases reasonable people could disagree about the virtuousness or evilness of an investment. Of course, when I say “evil investor” I merely mean one that invests in companies that fail the ESG screen – not that they are literally evil people. With that out of the way …

There are a few issues with ESG investing, some of which may not be obvious:

1. There is no universally, or even widely, accepted definition of an evil company. One person’s “arms dealer” is another person’s “defense contractor.” So, it isn’t clear which investments should be avoided. Google’s motto was “don’t be evil” yet they are frequently considered evil by at least some people.

2. ESG investments are screened, not weighted. In other words, if it is evil it gets zero investment. If it is “not-evil” (which is different from virtuous) it gets full investment. So, rationally, companies should be a little evil – little enough not to be screened out, but as much as is consistent with high returns otherwise.

3. Evil investors will get higher returns. As virtuous investors avoid evil investments the price declines, which is simply another way of saying the expected return rises.

4. There is a temptation to think that by investing in virtuous companies the returns will be higher – virtuous investors can have their cake and eat it too. It is easy to imagine that evil companies will have higher costs or lower sales (or both) because of their practices. But if that is true, they are not just evil, they are stupid. An evil businessman might not particularly care about the environment or women’s rights, but he is unlikely to actually reduce earnings to try to harm either! Thus, the argument that virtuous stocks are good investments, can ignore the ESG part. Unless, somehow, you believe the market is not pricing the expected returns of evil investments correctly. This seems unlikely.  My guess is that management errs more frequently the other direction – a CEO would actually give up some shareholder return to be seen as virtuous and this is actually an agency cost problem, not a benefit.

If you want to make the world a better place, it is far more efficient and effective to do it through direct contributions of time or money to charities and causes you support than to try to indirectly help through your investment portfolio.

I have been thinking for a while about how much umbrella liability coverage someone should have.  The rule of thumb that people should carry an amount equal to their net worth seemed wrong a few ways:

• Warren Buffett needs a $85 billion dollar policy?
• Assume a $2mm claim where the insureds used the rule of thumb:
  • The person with $1mm net worth is wiped out
  • The person with $2mm net worth is fine

I think I have solved the problem though.  To simplify the analysis, assume for the moment that:

• The insurance is priced at the pure cost of insurance.  In other words, the magnitude of the claims times the probability of the claims.  Thus, there is no profit margin, expenses, etc. for the insurance company.
• The insured is essentially risk neutral.  In other words, we don’t care about being insured, and given the previous assumption we are indifferent to carrying the insurance.  (Because on average we lose the same amount either way – through claims or through premiums.)

Because the odds of a claim go down with the size of the claim the initial amount (the first $1mm say) will cost more than additional amounts (the second $1mm should be cheaper, the third $1mm cheaper still, etc.).

Since the insurance is accurately priced, it might seem that there is no way to determine how much to buy.  The first $1 million is fairly priced, but so is the second, etc. and we are indifferent.  BUT we don’t actually get that amount of coverage.  Imagine I have a net worth of $1mm and I buy a $1mm policy.  I have paid (in my idealized example) exactly the right amount for it.  But suppose I have a net worth of $50k and I buy a $1mm policy.  It costs the same amount (it’s still a $1mm policy after all), but it is only “saving” me $50k – I can’t lose more than my net worth!  So in this case I am paying 20x the amount I should for coverage.  (I know I am ignoring wage garnishment, but I am keeping this simple for the moment – I’ll make this more complete below.) So I should buy the amount that matches my net worth so as to match the cost to the value to me.

Of course my example above is too simplistic, so here are the other considerations:

1. Reasons to buy less than net worth:
   1. Insurance companies charge more than the expected losses (of course) to cover their overhead, direct expenses, and to profit.
   2. There is likely an adverse selection problem where if you are buying out of an abundance of prudence, you are likely in a risk pool that includes at least some people who know they are prone to problems.  I.e. the premium covers the average person and you are likely less risky than average if buying this as part of a well-thought-out and prudent financial plan rather than because you know you sometimes drive while impaired.
   3. Much of your net worth may not be attachable by creditors (which is what the folks suing become if they win).  “Net worth” should be reduced by retirement plans, insurance and annuity cash values, spendthrift trusts, etc. In short, anything that isn’t available to satisfy a judgment.
   4. Competition (and lack thereof) probably makes small amounts correctly priced, but larger amounts less so.  In other words, there are so many companies that will write a $1mm policy the prices are probably not too much above the expected claims.  A $20mm policy is probably priced well above the expected claims.  (I have no data on this, I am merely speculating – but I am pretty sure I am right.)

2. Reasons to buy more than net worth:
   1. Since we are in fact risk averse, having extra (to avoid our $1mm net worth being wiped out by a $2mm claim) can make sense.  Since wealth has decreasing marginal utility, the small amount we pay for premiums costs much less in utility (happiness) than then large possible losses in utility – even adjusted for the differing probabilities (100% chance of paying a small premium vs. much less chance of a large claim).
   2. To the extent your wages can be garnished (even after going through bankruptcy) the PV of future wages (i.e. human capital) should be insured too.

So, here’s how to determine the appropriate amount of coverage:

1. Compute your net worth.
2. Add the PV of your future wages to account for 2b above.
3. Subtract any protected amounts (retirement plans, PV of protected portion of wages, home equity that has homestead exemption, etc. – see here for a comprehensive list) to account for 1c above.
4. Round up by $1mm (or more depending on risk aversion) to account for realistic risk aversion.  In other words, I think 2a trumps 1a, 1b, and 1d for most folks.

My latest quarterly ramblings to my Financial Professionals list are out: Financial Professionals Spring 2019

This will start a little technical (and seemingly off-topic), but should quickly get relevant and may cause you to see some things in a new light.

To begin, we need to discuss synthetic securities, and I will use stocks as the easiest one to understand. Suppose you have a non-dividend-paying stock that is trading at $50 (we could use any security that has options on it but for simplicity I will use the term “stock” throughout this piece, but you could replace it with the generic term “the underlying” with no loss of applicability if you like). If you wanted to “own” (replicate) the upside of that stock over the next three months, you could buy a call with a $50 strike price maturing in three months. If you wanted to “own” the downside of that stock over the next three months (I know it sounds weird – why would you want to do that? – but stay with me) you would sell a put with a $50 strike price maturing in three months. You could also purchase a t-bill that matured in three months at $50. (You’ll see why that matters shortly.)

Now, the interesting thing is that we can create any one of these instruments with any three of the others. For example, the stock we have been discussing is exactly equal to being long the call, short the put, and long the t-bill. Mathematically, it looks like this:

S = C – P + T

Any value that the left of the equation goes to in three months the right side will match perfectly. These relationships must hold because if there were an inequality, it would allow a risk-free arbitrage opportunity. For example, if the stock was too expensive you could short the stock and go long the instruments on the right and arbitrage the difference.

The interesting part is that with simple algebra we can rearrange this equation. For example, we can move the call option to the other side like this:

S – C = T – P

The left side of this equation is covered call writing (long the stock, short the call) which is widely considered a relatively safe “widows and orphans” type strategy. Perhaps you have noticed though that it is exactly the same as buying T-bills and selling naked puts on stocks – a strategy that most folks would consider insanely risky!

We can also rearrange to remove the risk of the stock. Suppose we are long the stock, short the call (we sold the upside), and long the put (we bought protection against the downside):

S – C + P = T

This is a really tight collar and as you can see gives you T-bill returns. (Before you get clever ideas, the tax laws would consider this a constructive sale of a stock position.)

Now in real life there are complications like dividends and the fact that the options are usually purchased out of the money. These changes make the math complicated but don’t change the underlying reality – when you do covered call writing, you are effectively buying bonds and selling naked puts, or, as the saying goes, picking up nickels in front of a steamroller.

I don’t think it changes the overall point that this “conservative” strategy is actually extremely risky, but there are two reasons that selling calls can add a little value. (The same holds for selling puts for that matter – because of the equation above I can make puts out of calls or calls out of puts by combining with stocks and T-bills – just rearrange the equation – and “put/call parity”, as it is called, exists.) First, the price of the option is based on expected volatility and historically the expected volatility is higher than the volatility that is actually realized. In short, options are probably a little bit too expensive on average (though Nassim Taleb, of Black Swan fame would argue the opposite and I’m not sure he’s wrong) so selling them (as in a covered call writing strategy) might earn a small premium. Second, there is a well-known effect called the “volatility smile” where if you graph the strike prices of the option on the x-axis and the volatility of the stock implied by the market prices on the y-axis it should be a straight line, but it generally forms a “smile” which just means that the further away from the current market price the strike price is (i.e. the more out-of-the-money or in-the-money an option is), the more expensive it is (options on stocks with higher volatilities are more expensive). Thus, out-of-the-money options are potentially too expensive. There isn’t a clear reason why this should be so, but it may be related to people’s preference for lottery-type payoffs and willingness to insure against catastrophic losses even at higher prices. Here is a graph of the volatility smile:

In short, I would caution against using covered-call-writing as a strategy unless you were also comfortable with owning a bond portfolio and writing naked puts – it’s the same thing!