Category: Investing Insight

Investing insight to make you a better investor.

Mandates, or lack thereof

Individual investors’ greatest advantage is that they don’t have to fit into a “style box.”

If you can’t measure it, you can’t improve it. – Peter Drucker

The Industrial Revolution was fueled, in part, by the violent combination of applied statistics and physics. Rapidly improving methods of measurement lead to rapid innovation in both the underlying physics and the resulting machine. And in an era of rapid innovation, managers who could zero-in on the metrics that mattered the most and measure them with decent precision had a large competitive advantage over the innumerate. For instance, if a new type of cotton ginny was invented, you needed a quantitative method to figure out if it was worth replacing the existing ones.

Managers who measured well survived. And those who survived, preached.

Take education, for example. Before the Industrial Revolution, one would simply be an “Oxford graduate.” There were no grades. Once your advisor thought that you were “ready,” you graduated. It was the industrialists who demanded scoring and ranking as a way to fit graduates into roles. And educational institutions obliged.

And it was all downhill from there.

When a measure becomes a target, it ceases to be a good measure. – Goodhart’s Law

While measurement and metrics are helpful in the physical world, it tends to break apart in the social world.

Measuring Investments

The first modern mutual fund was launched in the U.S. in 1924.

CRSP completed the stock market database in 1964.

The CAPM was introduced between 1961 and 1966.

Morningstar Style Box for mutual funds was introduced in 1992.

SEBI finalizes the Categorization and Rationalization of Mutual Fund Schemes in 2017.

For more than 40 years, investors were happy knowing absolute returns – how much was invested, what it is worth now and how long it took. And they were plodding along just fine for more than 70 years without the Style Box. But now, there are a dozen different ways to measure investment returns across an equal number of investment styles. How did we get here?

The Agency Problem

The Agency Problem or the Principal-Agent Problem occurs when one person (the agent) is allowed to make decisions on behalf of another person (the principal).

Within asset management, compensation structures in large part drive managers’ interests, and if these contracts are not structured correctly, managers may have an incentive to act counter to the fiduciary duty they have to their investors. Furthermore, investors’ tendency to focus on short-term performance may indirectly provide managers with additional incentives that exacerbate this problem. The Principal–Agent Problem in Finance

In every bull market, there are a certain class of funds that focus on the meme stocks of that period. These “go-go” funds, focused on growth stocks and other high-risk securities, offer higher risks, but also higher potential returns. Typically, when the bull market eventually comes to an end, investors end up holding the bag while the asset manager would’ve earned enough in fees to retire.

Stakeholder Rights and Obligations

There are quite a few stakeholders in the asset management industry:

  1. The buyer/investor.

  2. The seller/manager.

  3. Independent/Sell-side/Buy-side analysts.

  4. Rating agencies.

  5. The broker/distributor.

  6. The advisor/allocator/consultant.

  7. The regulator.

  8. The tax-payer/government.

As the asset management industry grew, the number of people involved in creating, (re)packaging, advising and selling them grew as well. Often, the interests of each of these stakeholders are in conflict. Increasing popularity of metrics and measurement in the industry is essentially an attempt at keeping these stakeholders honest.

Mandates

A barometer measures pressure. A thermometer measures temperature. Pressure and temperature exist independently of barometers and thermometers. This is true about any physical environment. Social environments are different. Measuring something could very well alter the very thing being measured. This is true about asset management as well.

For example, how should a bond fund manager be incentivized? If it were only to beat an index, then he could just play Russian-roulette with risky high yield bonds – he gets paid for excess returns (every year) when they work and you hold the bag when it blows up (eventually, some time in the future.) So, you put some restrictions on what he can do: only AA or higher with durations less than 3 years; not more than 10% of the fund in the same issuer/promoter, etc.

These restrictions are called mandates.

Mandates drive everything in professional asset management. It sets down a common operating principle and a set of metrics that all stakeholders can agree on.

In fact, the failure of the Indian mutual fund industry to narrow down mandates led to SEBI fixing it themselves. Before SEBI’s edict, it was common for fund houses to have multiple funds in the same category and play the survivorship bias game.

The rational behind Morningstar’s Style Box was the same as well.

Metrics that sit on top of mandates allow stakeholders to rank how individual managers have performed.

Where there is a Match, there is Match-fixing

The problem with mandates is that if you make it too strict, then beating the benchmark becomes nearly impossible and if you make it too lax, then agency problems raise their ugly heads.

US bond fund managers were able to beat their benchmarks mostly by taking additional risks: term risk, corporate credit risk, emerging markets risk, and volatility risk. Traditional discretionary active bond strategies offer little in the way of true alpha. AQR, 2018.

Given that investors care primarily about the most recent three-year performance, the pressure to front-load returns is huge. A case in point is the recent Franklin Templeton debt funds fiasco.

Despite the regulations being clear, some mutual fund schemes seem to have chosen to have high concentrations of high risk, unlisted, opaque, bespoke, structured debt securities with low credit ratings and seem to have chosen not to rebalance their portfolios even during the almost 12 months available to them so far. SEBI’s statement on Franklin Templeton dated May 7, 2020

Metrics are notoriously unstable

Finance doesn’t have immutable laws of nature. The “physics envy” that finance academics have is obvious in the body of research they have produced – precise equations modeling a complex-dynamic-adaptive system. But the desire to tame the beast that is the asset-management industry has lead to too many rigid frameworks and restrictions placed on all the stakeholders.

There is absolutely zero stability in metrics used to analyze mutual fund performance. Whether it is alpha, beta or information ratio, they all vary over time and across market environments. Using them to pick the next “winning” fund is pointless. They are, at best, a measure of what happened in the past. – A quick note on performance metrics

So you have tighter mandates and unstable metrics. But the bigger question is: as an investor, do you want relative performance or absolute returns?

Free your mind

The problem with bucketing yourself as a “value investor,” “contrarian,” “growth,” or “momentum guy” is that you lose the biggest advantage that you have: flexibility and the ability to adapt to the market.

Fund managers, at the end of the day, are only human. They too suffer from confirmation bias. And to make matters worse, once they reach a certain level of fame, all their holdings are closely tracked and their decisions questioned. Once publicly committed to a position, they find it very difficult to backtrack and admit mistakes. You, as an individual investor, have no such pressure.

To top it all, the fund management business is geared towards the accumulation of assets. They are paid a % of assets under management (AUM,) after all. However, size is the enemy of outperformance. With break-evens running at Rs. 100 crore per fund, the “no-go” zones for managers are pretty large. You, as an individual investor, have no such constraints.

There is an oft repeated cliché that you should invest within your “circle of competence.” Most people use this as an excuse to keep fishing in the same pond till the water is dry and the fish are dead. Instead, you should think of it as a call to action. If you are not constantly learning and increasing your circle of competence, then what exactly are you doing with your life?

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Short Squeeze

Always know if the juice is worth the squeeze

Unless you’ve been living under a rock the last month, you couldn’t have missed the GameStop (GME) short squeeze. A stock that was trading below $3 a few months ago suddenly shot up to $483 before collapsing to $63 yesterday. While the media narrative focused on how a bunch of YOLO traders in a subreddit took on Wall Street, what it really was, was a short-squeeze of epic proportions.

Why short a stock?

There are a lot of legitimate reasons to short a stock.

  1. You think a company is committing fraud. You short the stock and publish a report hoping to convince other investors to short it along with you and draw regulators to investigate the company.

    Twitter avatar for @HindenburgResHindenburg Research @HindenburgRes
    NEW FROM US: Clover Health: How the “King of SPACs” Lured Retail Investors Into a Broken Business Facing an Active, Undisclosed DOJ Investigation cc @chamath hindenburgresearch.com/clover/ $CLOV (1/x)Clover Health: How the “King of SPACs” Lured Retail Investors Into a Broken Business Facing an Active, Undisclosed DOJ Investigation(NASDAQ:CLOV) Today, we reveal how Clover Health and its Wall Street celebrity promoter, Chamath Palihapitiya, misled investors about critical aspects of Clover’s business in the run-up to the comp…hindenburgresearch.com

    February 4th 2021

    711 Retweets

  2. You think a company is headed towards bankruptcy where the stock is going to be worth zero. You short the stock and publish a report hoping to convince other investors to short it along with you1.

  3. You run a relative value or merger-arbitrage strategy. You go long company A vs. short company B, pocketing the spread. For instance:

    IBM’s bid for multinational software company Red Hat is a case in point, he says. ‘Red Hat had declined, its stock had gone down from a $170 peak in the summer to trade at $150 in Q4 and then it dropped to $120 before the IBM bid. So a $120 stock gets a $190 offer and, ironically, the market prices in a wider spread.

    ‘That’s a 60% premium but it wasn’t really much of a premium when you look at where Red Hat had been at its height.’

  4. You are mostly long stocks or bonds and you want to limit your downside by shorting stocks.

  5. You want to express a macro view. For example, if you think the entire housing market is going to collapse, then you can express that view by shorting housing stocks, housing-credit, etc.

Short-selling is an essential lubricant of the markets. It makes the market more efficient2.

When does it go wrong?

The problem with short-selling is that it has always seemed “wrong.” Elected representatives want to be seen encouraging entrepreneurship and short-sellers are the proverbial thorn in their sunny-skies-forever narrative. Over a period of time, this tilt against shorting has rigged the market to overwhelmingly favor longs.

To short-sell (i.e., sell a stock that you don’t own,) you need to first “borrow” it from someone. The lender demands that he be paid a fee for it. And if the stock price goes up, the borrower owes the difference to the lender. Also, in some cases, the lender has the right to recall the securities with little notice (“at call” 3.)

Usually, short-selling is as boring as long-buying. The practice is well understood and usually goes on without a hitch. But ever so often, things tend to go spectacularly wrong.

Asymmetric payoff

Suppose a stock is trading at Rs. 100 and you decide to short it. Your maximum profit is Rs. 100 whereas the person taking the long-side of it has no such limit to the upside. If the stock starts going up, you really have no way of telling what the eventual loss is likely to be. Beyond a certain limit, you’ll try and cover your short by buying the stock back in the market. But what if there are not enough stocks for you to buy?

Liquidity

There is a big difference between total market cap4, free float market cap5 and the number of shares that can be traded without making an impact6. Take Infosys (INFY,) for example.

Its total market cap is Rs. 5,42,24,574.74 lakhs and free float market cap is Rs. 4,71,41,375.59 lakhs. This means that more than 85% of the total number of stocks is available to trade. But on any “normal” day, only a small fraction of it trades. In INFY’s case, its 0.15%. And all this happens with an impact cost of 0.02%.

Now, contrast this to HATHWAY. Its free float is only 6% and about 1% of it trades in a day with an impact cost of ~1%

If you were equally bearish on these two stocks, which one is a better short?

The answer is INFY.

You are not the only shark in the tank

The biggest mistake that most investors make is assuming that they are the only player in the field. But the market is filled with sharks that will rush towards a drop of blood at the slightest hint.

In our example, when you short INFY, given the sheer amount of stocks available in the market, your actions are unlikely to raise eyebrows. However, if you shorted HATHWAY, then things are going to get interesting for you.

The dynamics of a short squeeze

Lets say that you are so bearish on HATHWAY that you decide to short about Rs. 100cr worth of the stock. Assuming that you were conservatively leveraged at 2x, all you had to do was put up Rs. 50cr in capital. But the total free float is Rs. 322cr and only about Rs. 1.7cr in value gets traded every day.

Either the news gets out that someone is short or the hero that you are, you send out a research report on why the company should be worth zero and everybody else should join you.

However, the sharks have their own take on this. It wouldn’t take much to move the price of a stock that trades only Rs. 1.7cr in value a day. Instead of shorting along with you, they decide to buy it. With its high impact cost, even a few small accounts buying 1-10 lakhs every day is enough to push the stock higher.

Now, you are on the clock. Every day, you have to post margin to maintain your short. You see the price go from Rs. 30 to 32, then to 35… 40. A 30% rise in price means that you have lost Rs. 30cr on a starting capital of Rs. 50cr. You decide to throw in the towel and buy some of the stock back. The sharks smell blood and move in for the kill.

There are no stocks to buy.

?? ???

Diamond hands to the moon.

You panic close your short and send the stock rocketing to the moon.

This is exactly what happened to GameStop last month.

Not the first time, and will not be the last

Short-squeezes have been around since the dawn of markets.

The earliest one in recorded history was Piggly Wiggly7, circa 1923. A short-squeeze sent the shares of the department store from $40 to $124. But in typical Wall Street style, when the going got tough, they just changed the rules8.

The shorts were cornered and only had until the next day (Wednesday) to deliver their shares. But then, the rules changed.

The Governing Committee of the Exchange announced a suspension in Piggly Wiggly trading and an extension to the short sellers delivery deadline. Saunders countered and offered a deal of $150 a share for delivery by end of day Thursday and $250 a share thereafter.

Unfortunately, very few short sellers came forward to pay Saunders what he wanted. Then, the Governing Committee delivered the death blow to Saunders. They restricted trading of Piggly Wiggly and gave the short sellers until the next Monday to deliver the shares.

The extension granted by the Committee gave the shorts enough time to find other shareholders across the country (i.e. widows and orphans) who they could buy shares from. Instead of getting paid in dollars, Saunders got the last thing he wanted—more Piggly Wiggly shares.

By the end of day Friday, most of the shorts had covered their positions and Saunders was left holding the bag while still $10 million in debt. He had lost. Wall Street had won.

One of the more memorable squeezes before GameStop was the Volkswagen Infinity Squeeze in 2008. Volkswagen was increasingly being viewed as a potential bankruptcy candidate. However, an orchestrated short squeeze on VW shares caused VW to briefly become the most valuable company in the world, worth more by market cap than Exxon Mobil.

On October 26th, 2008, rival automaker Porsche made a surprise announcement that it had increased its stake in VW to over 74%. It was a stealth move, made possible through the use of multiple purchases of cash-settled derivatives which had been accumulated separately through different European investment banks.

The short interest9 seemed not excessive, at just 12.8% of outstanding shares. But what the market failed to appreciate was that the true availability of tradeable shares to cover those short positions was actually far lower than what many understood.

Around 55% of VW shares were already unavailable in the market for any realistic purposes (mostly owned by index funds and sovereign wealth funds.) As a result, when Porsche increased its stake by an additional 44%, it meant that the true available float went down from 45% of outstanding shares to around just 1% of outstanding shares. Suddenly the seemingly “low” short interest of 12.8% turned in to a massive supply and demand imbalance. Millions of shares needed to be bought immediately even though there were simply no shares available to be sold.

Following the announcement by Porsche, the resulting panic caused a short squeeze in VW shares that saw the deeply troubled automaker briefly become the most valuable company in the world – despite being in the middle of the worst financial crisis since the great depression. VW’s share price briefly exceeded €1,000 intraday with a market cap of over €300 billion.

As a result of its skillful financial engineering, Porsche netted itself more than $10 billion in profits in a matter of just a few short weeks.

On the other side of the trade, the hedge funds who had sold VW short quickly saw their collective losses exceed $30 billion.

The odds are forever against you

Short-sellers have to navigate a lot of asymmetries to emerge successful in the long term.

  1. Most of the world in long-only and that tilts politics against the short-sellers.

  2. The P&L profile is that of unlimited downside vs. limited upside.

  3. Crowded trades end in squeezes.

  4. No company ever hands out bad news if they are not forced to.

  5. The rules of the game can always be changed.

Does this mean that you should go squeeze hunting? Not necessarily:

  1. Short-interest data can be misleading if most of the longs are #neversell or in funds that cannot lend out those stocks to short-sellers.

  2. Most of the time, the shorts are legitimate and squeezing them requires a shift in the zeitgeist.

  3. The reaction of the management when this battle is being fought is a wildcard that cannot be modelled.

In the end, is the juice worth the squeeze?

4

Outstanding number of shares of a company multiplied by its current market price.

5

The value of the company calculated by excluding shares held by the promoters.

6

Impact cost is the cost that a buyer or seller of stocks incurs while executing a transaction due to the prevailing liquidity condition. It varies by transaction size and depends on outstanding orders.

9

Short interest is the number of shares that have been sold short but have not yet been covered or closed out.

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define: ethereum

an alternate parallel digital universe

A 17-year old boy looks at bitcoin and sees the possibility of creating a world computer that can run an alternate universe. His name: Vitaly Dmitriyevich “Vitalik” Buterin.

Vitalik dropped out of school in 2014 when he was awarded with a grant of $100,000 from the Thiel Fellowship to work on Ethereum full-time.

To understand Ethereum, one needs to first understand massively multiplayer online role-playing games (MMORPGs.)

Games, Networks and Virtual Universes

Parents have been yelling at their kids since the days of Atari’s Pac-Man about spending too much time in front of the screen.

It will melt your brain! Why don’t you go out and play like normal kids!

Over the last four decades, games got progressively realistic, immersive, networked, multiplayer, and pervasive. People started spending more on games, gaming rigs, and consoles. Video game makers moved away from a one-time, hit-based production system to creating virtual spaces where gamers can write their own story. The metaverse was born.

The metaverse is to game makers that SAAS is to enterprise software. Once a metaverse crosses a tipping point, network effects kick in and revenue explodes. Some gamers, the whales of the metaverse, spend an obscene amount of real money buying virtual goods. Everything is for sale – avatars, dresses, weapons, skills – inside the metaverse.

Globally, recent estimates for annual virtual-goods revenues have totaled over $52 billion.

Gaming evolved into a sub-culture onto itself.

Boredom Kills

Metaverses have a big problem: they can implode if they get boring.

Back in 2003, Linden Lab launched Second Life – an online virtual world. By 2013, it had about one million regular users. Users, or residents, as they are called, can login using client software and create virtual representations of themselves, called avatars, and are able to interact with places, objects and other avatars. They can explore the world (known as the grid), meet other residents, socialize, participate in both individual and group activities, build, create, shop, and trade virtual property and services with one another.

The platform principally features 3D-based user-generated content. Second Life also has its own virtual currency, the Linden Dollar, which is exchangeable with real world currency (wikipedia.)

At the peak of its hype-cycle in 2006, American Apparel had a virtual store and even IBM had set up a “property.”

And then it died.

While media articles on its failure focus on buggy software, missing the switch to mobile, etc, the biggest reason was that it was owned by a company (centralized decision making,) that had to host and pay for the servers themselves (centralized scaling,) and there could be only one Second Life.

Ethereum is a platform on which another Second Life can be created on a distributed network not owned by a single corporation.

Ethereal

In a nutshell, the Ethereum platform allows programmers to write code that runs on a distributed network. To incentivize miners to run the code, they are paid in Ether (ETH.)

The code is called a smart-contract and to run it, you need to supply it with ETH. The code will do the work and consume the Ether. Both the code, and the ledger keeping track of ownership of the Ethers, are on a blockchain.

Technically, the code runs on many computers across the world, computing and storing data locally, but networking globally, to create a distributed ledger which is sometimes also called “a blockchain”.

With these basic building blocks, one can construct self-contained virtual worlds with virtual goods, etc.

Cryptokitties

CryptoKitties was the first mainstream use case for Ethereum’s blockchain. It operates as a non-fungible token (NFT), unique to each CryptoKitty. Each CryptoKitty is unique and owned by the user, validated through the blockchain, and its value can appreciate or depreciate based on the market. These virtual kittens (tokens) are also traded on crypto exchanges.

What is fascinating is not just the technology but the storytelling that made it real. The kittens are unique, supply-constrained, have traits (some of which are rare) that can be passed on through breeding, etc. There is an ecosystem of tastemakers and specialists around it that keep the story alive. And consumers willing to part with real money for virtual kittens.

DeFi – Decentralized Finance

Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance, and more — accessible to anyone in the world with a smartphone and internet connection.

There are DeFi dapps that allow you to create stablecoins (cryptocurrency whose value is pegged to the US dollar), lend out money and earn interest on your crypto, take out a loan, exchange one asset for another, go long or short assets, and implement automated, advanced investment strategies.

This is a nightmare for regulators like SEBI and the RBI who are tasked to protect consumers. Who are you going to sue and who are you going to jail when there is no “owner” as in the real world?

For better or for worse…

Ethereum is the biggest crypto-currency after Bitcoin. There is a large ecosystem around the infrastructure breathing life into this alternate parallel virtual universe. It is here, it exists, and it is growing.

Some think that the current economic and political order is an accident of history. What if we had the opportunity to evolve an alternative? What would it look like? Don’t we owe it to ourselves to find out?

We leave you, dear reader, with these thoughts and a recording of our fascinating conversation with someone who is working on a PhD in crypto-currencies and who also happens to be a dear friend of mine. Enjoy!

Further reading: An Economic Analysis of Ethereum

Previously: define: bitcoin

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define: bitcoin

an infinitely divisible digital collectible

The Problem

When faced with a cash-crunch, whether due to wars or natural calamities, the first instinct of governments since time immemorial has been to debase their currency.

Take the Roman empire, for example. The major silver coin used during the first 220 years of the empire was the denarius. During the first days of the Empire, these coins were of high purity, holding about 4.5 grams of pure silver.

However, with a finite supply of silver and gold entering the empire, Roman spending was limited by the amount of denarii that could be minted.

This made financing the pet-projects of emperors challenging. How was the newest war, thermae, palace, or circus to be paid for?

Roman officials found a way to work around this. By decreasing the purity of their coinage, they were able to make more “silver” coins with the same face value. With more coins in circulation, the government could spend more. And so, the content of silver dropped over the years.

By the time of Marcus Aurelius, the denarius was only about 75% silver. Caracalla tried a different method of debasement. He introduced the “double denarius”, which was worth 2x the denarius in face value. However, it had only the weight of 1.5 denarii. By the time of Gallienus, the coins had barely 5% silver. Each coin was a bronze core with a thin coating of silver. The shine quickly wore off to reveal the poor quality underneath.

By 265 AD, when there was only 0.5% silver left in a denarius, prices skyrocketed 1,000% across the Roman Empire.

Traditionally, citizens of a country have limited options to escape a government hell bent on debasing their own currency. They could buy gold, but the government can find ways to restrict how much gold one could own. For instance, the US restricted gold ownership for over 40 years claiming that “hoarding” of gold was stalling economic growth and worsened the depression. In some left-leaning countries, people default to using the US Dollar as a store of value. But often, like in the case of Argentina in 2001, the government can freeze bank accounts and restrict withdrawal of hard currency. One could try to accumulate hard assets, like land, for example. However, real-estate is not portable and can always be sized by the government, like India in the 1950’s and South Africa in the mid-2000’s.

Each of these traditional assets have trade-offs.

  • Gold: cannot be used for electronic payments. But everybody knows its price and is a trusted store of value.

  • US Dollar: centralized clearing either through SWIFT or ACH means the US Government can shut you off at any time. But it is a widely accepted medium of exchange (world trade is denominated in it.)

  • Hard assets: not portable, one-of-a-kind, tough to value and transact with a high liquidity premium. But is known to hold its value through inflationary environments.

Bitcoin was designed to overcome most of these problems.

The Solution

Bitcoin is meant to be a decentralized, fixed-supply, infinitely divisible, digital currency.

Decentralized: there is no central ledger or clearing-house for bitcoin transactions. All bitcoin transactions are written on a blockchain. To win the right to write to the blockchain, miners compete and if they win, are awarded bitcoins. Anyone can become a miner, so transactions are settled by a distributed network of miners that does not require a central authority.

Fixed-supply: there can be only 21 million bitcoins in total. This makes it impossible to be debased like regular currencies.

Infinitely divisible: bitcoin’s smallest unit is called a “satoshi.” It represents one hundred millionth of a bitcoin, or 0.00000001 BTC ($0.00035 USD, at current price.)

Digital: you access your bitcoins through a unique 34-character key. There is no other identifier tying you to your bitcoins. You can use many such keys to send, accept, and store your bitcoins anywhere in the world.

A shared illusion

As far as I can tell, money is a shared illusion. We have a lot of beliefs in various systems, whether it’s the universe or government or organized religion, that serve more of an existential function to give us a sense that there is some order in the world. A big part of money’s function is the ability to help us measure things in an understandable way. – Adam Waytz, Kellogg School of Management

Money is whatever a group of people can agree on that is

  1. a store of value

  2. a medium of exchange

  3. a unit of account

It is not necessary to use a government-issued currency (fiat) to achieve these ends. However, since taxes can only be paid in fiat and the government can use violence to extract the taxes owed, it is often convenient to keep using it.

It is no wonder that even though the technical pieces of bitcoin have been around since the mid 90’s, it took the shock of the 2008 Global Financial Crisis to breathe life into it. With widespread panic, bank runs, countries at the brink of default, and evaporating faith in the global financial system, the time was ripe for an alternative to emerge.

An elegant solution to a well defined problem… with trade-offs

From a technical point of view, bitcoin does what it says on the tin. And the code that drives all of it is public. There are no surprises. But every solution has tradeoffs. Bitcoin’s biggest trade-off is that settling transactions is extremely slow and expensive.

There is no hard limit to how long bitcoin transactions can take to be confirmed. It can take anywhere between 10 minutes and over a day. The two biggest influences on the confirmation time are the amount of transaction fees and the activity on the network. This is not something that can be used for micro-payments, like buying a cup of coffee. But this is only one part of the problem.

New bitcoins enter circulation as block rewards, produced by miners who use expensive electronic equipment to earn or mine them. Every 210,000 blocks, or roughly every four years, the total number of bitcoin that miners can potentially win is halved. But the consequence of this dropping block reward is that eventually, it will dwindle to nothing.

In a few decades when the reward gets too small, the transaction fee will become the main compensation for nodes. I’m sure that in 20 years there will either be very large transaction volume or no volume. – Nakamoto

When you learn that the total annual energy consumption of the Bitcoin network is comparable to the power consumption of Chile, you’ll immediately understand why this is a problem.

This makes #2 of what makes something money questionable in the context of bitcoin. If you can’t use something to transact for everyday needs, is it really money?

Volatility kills accountants

The volatility of Bitcoin is roughly three times higher than that of most country currencies. Compared to a currency pair like USDCAD or USDEUR, which barely breaches 2% (10-Day) volatility even during the Great Financial Crisis, Bitcoin at its lowest volatility is lucky to be below 2%. And this is true even if you compare it with other least-developed country currencies.

The problem with this kind of volatility is that if you own bitcoin denominated assets, what is it worth? This makes the #3 reason of using something as money questionable in the context of bitcoin.

Bitcoin is more like art, less like money

Picasso’s Les femmes d’Alger was sold for $179.4 million in May 2015.

What makes a piece of art valuable? It just sits there and does nothing. So, like bitcoin, it obviously has no intrinsic value. And, like bitcoin, supply is usually capped because the artist is usually long gone. Also, like bitcoin, there is an ecosystem around art comprising of auction houses, galleries and museums that promote a shared myth.

The #2 and #3 use-cases of money is barely met by bitcoin. But bitcoin fits nicely into the art metaphor. With two big differences.

  1. Art, unlike bitcoin, is not divisible. This means that the price of a piece of art is capped by how much someone is willing and able to pay for it. Bitcoin has no such constraint. If someone with $10 buys a fraction of bitcoin for $50,000, then that price gets printed.

  2. Bitcoin is completely digital. Bitcoin represents digital scarcity, which, before Bitcoin, had almost no solutions. Before bitcoin, only things in the real-world were not “copy-pasteable.”

This makes bitcoin an infinitely divisible digital collectible.

We leave you, dear reader, with these thoughts and a recording of our fascinating conversation with someone who is working on a PhD in crypto-currencies and who also happens to be a dear friend of mine. Enjoy!

Sources:

Currency and the Collapse of the Roman Empire

Executive Order 6102

Corralito

Zamindar

Land reform in South Africa

Money: The myth we all believe in

Crypto Assets

How Long Do Bitcoin Transactions Take?

Bitcoin Halving, Explained

Bitcoin Energy Consumption Index

Why Bitcoin Has a Volatile Value

Evolution of bitcoin: Volatility comparisons with least developed countries’ currencies

The Value of Art: Money, Power, Beauty

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Cross-Asset Time-series Momentum

Trend-following systems typically use the past performance of a particular asset to trigger a buy or a sell on that asset. A research paper that came out in 2019 looked at whether the historical performance of multiple assets can be used to trade them.

Pitkäjärvi, Aleksi and Suominen, Matti and Vaittinen, Lauri Tapani, Cross-Asset Signals and Time Series Momentum (January 6, 2019). Available at SSRN: https://ssrn.com/abstract=2891434

From the abstract:

We document a new phenomenon in bond and equity markets that we call cross-asset time series momentum. Using data from 20 countries, we show that past bond market returns are positive predictors of future equity market returns, and past equity market returns are negative predictors of future bond market returns.

Unfortunately, the paper did not look at Indian markets to check if this worked. So, we rigged up a simple backtest to see for ourselves.

Rules

A simplified equity-bond cross-asset trading strategy at the beginning of month t can be constructed as follows: Compute the past 12-month equity return (E past) and the past 12-month bond return (B past). If:

a) E past is positive and B past is positive: Buy equity
b) E past is negative and B past is negative: Sell equity
c) E past is negative and B past is positive: Buy bonds
d) E past is positive and B past is negative: Sell bonds
e) Otherwise, invest in the risk-free rate.
Hold the portfolio for one month and then repeat the same procedure in month t+1 (source.)

Backtest

We used the NIFTY 50 TR index to represent equities, NIFTY GS 10YR index for bonds and the CCIL Index 0-5 TRI for risk-free rate.

Since our risk-free index starts only from 2004, our backtest only goes back 16 years. However, the markets have been through a lot since then, so it is unlikely we are losing much by not being able to go back much earlier.

The 12-month look-back approach massively under-performs the NIFTY 50 TR buy-and-hold. We shortened the look-back to 3-months to see if we could make the strategy more responsive to trend reversals.

To our dismay, we saw only marginal improvements in overall returns but the draw-down profile of the long-only portfolio was much better.

Conclusion

While the approach outlined in the paper might be valid for the selected subset of markets, it fails a simple backtest on Indian market indices.

Code for the backtest can be found on github.

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