• K Squared Capital

Weekly Edition #54


In this edition:

Editor’s Note: Russian Invades Ukraine


As you’ve probably seen, Russia decided to invade Ukraine. Markets initially dropped (S&P 500 down around 2.5%) but eventually recovered and are actually up on the day (as we write this). Russia has been building up their presence at the Ukrainian border for some weeks now, and the US has been saying that Putin had decided to invade Ukraine for several days. No one can say this was a surprise, it has been a real possibility since at least a week ago. The reaction from US markets was fairly muted (like we said S&P is up around 0.3% and the Nasdaq is up close to 2%). What didn’t fare well are Russian and Ukrainian assets. A Russian stock market ETF (ticker RSX) initially dropped 32% and is now down around 15%. The MOEX Russian Index dropped close to 40% and closed down 34% for the day. Total market cap for the MOEX was $700 billion before the fall.


We’ve written many times before that things can come out of nowhere (this is not one of them, this was a probable event since several days ago), and undiversified portfolios can get wrecked in an instant. Even though an invasion was a real possibility, Russian markets still got crushed (and Ukraine as well, with some bonds down 50%). This is why we diversify, and this is why we invest outside of our home country (or the country that we live in), because things can change in an instant.


Imagine being in Ukraine and investing all of your assets in your home country. Let’s say you were “conservative” and decided to invest your money in your home country’s 10-year bonds, which yielded close to 10%. Now Russia invaded your country, your life is in danger, if you owned property, it went down massively in value (if it’s even possible to sell it now), and on top of that your financial portfolio is also down close to 50%! You might think, well nobody does this, but that’s not true! We’ve spoken with many investors who have told us “I am very conservative; I don’t invest abroad and only invest in “safe” assets such as Costa Rican government bonds”. Probably all of you reading this know better and have diversified portfolios, but you would be surprised how common it is for people to invest in what they know; and unfortunately, what people know best is CR government bonds (apologies for our international audience which this might not be as relevant). And this not only applies to individuals, some institutions are forced to (yes forced to by law) have a large percentage of their investable assets invested in their own country. Imagine Ukrainian pension funds right now (we have no idea how the Ukrainian pension system works or how they are invested, but they probably have a significant percentage invested in their own country’s bonds), if they had a large percentage invested in their own country’s bonds, they are in a very difficult situation right now (for our readers in these institutions, imagine this situation happening to your fund).


So, what do we do now? I spoke with several of you this morning, some expressed fear, others wanted to buy more, others were happy to just let things play out. With the caveat that nothing here is investment advice, we are sticking with our strategies and not making any changes to our portfolios. In the long run these short-term drops don’t really matter. However, what we do for us and for our clients might not be the best course of action for you. It all depends on your goals, personality, situation in life, portfolio composition, etc. In the end you need to do what will minimize your regret. The reality is that no one knows what will happen. We don’t know if Putin will wake up tomorrow and decide that this is enough and stop the invasion, or if he will decide he wants more and invade another country. We don’t know how the markets will react to any of those scenarios either. So, will you feel worse if you sell and markets rebound or if you don’t sell and markets fall?


If you are unsure what to do, then think of how you felt this morning and how you feel now. This morning S&P was down 2.63% and Nasdaq down 3.28%, now they are up 0.61% and 2.35% respectively (yes, markets have moved as we write this). Are you glad you didn’t sell? Are you thinking that this rally is an opportunity to get out before things turn back down? Think of the different scenarios, think what you will regret most, and finally put this in perspective. We are investors for the long term, in 5 or 10 years you probably will not remember this day, and if you do, you probably will barely be able to point it out in a chart.

And for all of you thinking, well this could never happen in my home country, then we urge you to read this. You’re probably right that an invasion is much less likely in your country, but other scenarios might lead to the same result for your portfolio. Especially in smaller economies like where we writing this form today (Costa Rica).


What Canada Means for Crypto


Canada has been roiled by anti-vaccine protesters and the government has invoked emergency powers designed to clear the protesters. As part of these emergency powers the government has asked banks to freeze around $6.1 million in accounts related to the protestors. They have also stopped around $3 million that was sent through payment processors from people who were supporting the protests. They have also determined 253 Bitcoin addresses that were used in connection with these protests.


This is a clear example that might be used by crypto enthusiasts to claim about why we need cryptocurrencies, to avoid government overreach. Even if you think the Canadian government is abusing their powers, crypto currencies are not the answer. Imagine you have your bank accounts frozen for doing some crime, but you have millions of dollars in Bitcoin. What do you do? How do you spend this Bitcoin? You cannot sell it on an exchange because your accounts are frozen. You cannot go to a store to buy anything. You would need to find another individual who would be willing to give you cash in exchange for Bitcoin (and they would need to be willing to bear the risk of transacting with someone who has had their accounts frozen). If you want to avoid government overreach you are better off holding cash than a crypto currency.


A Crucial Clue in the $4.5 Billion Bitcoin Heist: A $500 Walmart Gift Card



Bitfinex was (is?) a Hong Kong based cryptocurrency exchange which was hacked in 2016 and had $71 million in Bitcoin stolen. The couple which presumably stole the Bitcoin was caught a couple of days ago and charged with conspiring to launder money and defraud the federal government. The stolen Bitcoin are now worth around $4.5 billion (at the time of the article, now they could be worth 3 or 7 billion just as likely).


It turns out that, contrary to popular belief, using Bitcoin for crime is not a good idea. Any transaction done on the Bitcoin network is public for everyone to see. What is anonymous is who controls the wallet from which payments were made or received. There are sophisticated ways of linking wallets to specific people, but it requires specialized knowledge and access to a lot of resources. The main issue with Bitcoin, which we mentioned above, is that to actually be able to use it you need to convert it into fiat currency. And most avenues to do this are increasingly complying with anti-money laundering regulations (which is a good thing). This couple that was arrested were worth $4.5 billion on paper, but had to resort to buying $500 Walmart gift cards to be able to spend it…


Passive ETFs hit by billion-dollar rebalancing costs


Most ETFs (not all) are index based, this means that they follow a systematic, rules-based process to decide which stocks (or other assets) to buy and sell. For example, the S&P 500 has a committee that decides which stocks go into and out of the index. There are specific requirements of company size and profitability, but the committee has some discretion as to which companies make it. Typically the committee decides which stocks will go into and out of the index well in advance of when the change actually takes place. This gives market participants which are replicating the index enough time to plan their rebalancing trades.

There have been anecdotal evidence of savvy traders taking advantage of the programmatic nature of these index additions/deletions and trading before the large index mutual funds and ETFs need to trade. They therefore buy before the big money buys and enjoy an increase in price (called front-running). A new paper estimates that these front-running trades cost investors $4 billion per year. This paper has been controversial and many industry participants say that the methods used are wrong. However, we think that even if this is true (it is very hard to measure), using ETFs is still more efficient than buying active mutual funds (which almost always underperform). The $4 billion translates to roughly 14.6 basis points of underperformance; and ETFs are much cheaper than mutual funds. Therefore, even if index ETFs are suffering 15 basis points of drag because of how they rebalance, they more than make up for that in fee differences.



SEC Issues Proposal to Reduce Risks in Clearance and Settlement


This is a pretty in the weed’s topic relating to how US stock transactions happen. When you click the buy button on your online brokerage account, you will see the stock appear in your positions list and the amount of cash needed to buy the stock debited from your cash account. However, technically you do not own the stock for up to 2 days. This is how long it takes for the transaction to settle, basically for the seller to deliver the shares to you and for your broker to pay the seller. This used to be 3 days up until a couple of years ago and was longer before that. The SEC is now proposing to reduce this to 1 day.


One of the main benefits crypto enthusiasts tout is that Bitcoin or other cryptos take much less time to settle. However, as we’ve often mentioned, many things in our current system work the way they do not because of a lack of technology but because of how things evolved. If we were to design a system from scratch today, we probably wouldn’t have 2 day, or even 1 day settlement. But we have that now not because we lacked the technology to do it, but because it’s a system that evolved from one that used to take 5 days to settle.


Thanks for reading!


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Disclaimer:

Past performance is not a guarantee of future performance. Future returns are not guaranteed, and loss of capital may occur. This material is not to be reproduced or distributed to any other persons and is intended solely for the use of the persons to whom it has been delivered by or on behalf of K Squared Capital. This material is not for distribution to the public. The sole purpose of this material is to inform, and it is in no way intended to be an offer or solicitation to purchase or sell any security, other investment or service, or to attract any funds or deposits. The information provided herein does not constitute tax, accounting or legal advice. Investing in financial markets involves risk, including the risk of principal loss. Information in this document is in no way intended as personalized investment advice and should not be interpreted as such. Past performance is no guarantee of future results. K Squared Capital disclaims responsibility for updating information. In addition, K Squared Capital disclaims responsibility for third-party content, including information accessed through hyperlinks. Certain assumptions have been made regarding historical performance information included herein, and such performance information is presented by way of example only. No representation or warranty is made that the performance presented will be achieved as a result of implementing an investment strategy substantially identical or similar to that described herein or that every assumption made in achieving, calculating, or presenting the historical performance information has been considered or stated. Any changes to assumptions could have a material impact on the investment returns that are presented by way of example. Returns for any period may be attributable to certain market conditions, fund size, and timing of transactions, which may not be repeated. Diversification does not assure a profit or protect against loss in a declining market. Past performance is no guarantee of future results. Actual results may vary.


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