• K Squared Capital

Weekly Edition #64

Updated: May 13

In this edition:

Editor’s Note: Not Selling to Not Realize a Loss

We’ve heard many times of people not wanting to sell to not realize a loss. The theory goes that if you own stocks (or any asset) and they drop, say 15%, you don’t want to sell in order to lock in that loss. If you are a long-term investor then there’s no reason why you should sell, assuming nothing else has changed in your investment process, liquidity needs, etc. However, you may be in a situation in which you want to sell in order to allocate to a different investment.

Let’s imagine that a new fund launched, and you wanted to invest but your investment portfolio is down 10%. Assuming you are fully invested and have no spare cash, you have two options. Either sell part of your portfolio in order to move it to the fund or wait until your portfolio recovers and then invest. Many would take option two, wait until the portfolio recovered before making any moves. However, what has already happened (losing money in the portfolio) is completely irrelevant for the decision. What already happened is a sunk cost, something you cannot change even if you wanted to. The only thing that matters is what is going to happen going forward. Therefore, to make this decision you should only care about the characteristics of the new fund, it’s expected return, risk, diversification benefits, etc.

Let’s put some numbers to the example to make it clear. Let’s say you had $500,000 in an investment portfolio that dropped 10% and is now worth $450,000. Let’s assume this investment portfolio is invested in a globally diversified set of ETFs and is expected to return 5% over the long-term. You get an opportunity to invest in a new fund which is expected to return 10%. Finally, let’s assume you wanted to invest half of your portfolio in the new fund but don’t want to make any movements until it recovers back to $500,000. The correct answer in this case is to sell part of your portfolio and invest in the new fund. If your assumptions are correct, you will always make more money by investing in the new fund than waiting for your original portfolio to recover. In fact, if you were going to invest for 10 years you would make $76,018 (17%) more by making the move right now than by waiting for a recovery. Below are the numbers in case you want to check them yourself.

We’ve written about some things we all repeat because we think they’re true and haven’t really sat down to look through the numbers before. One of these previous truths was that you should invest and then pay taxes rather than paying taxes now and then investing (it doesn’t make a difference as long as the tax rate doesn’t change!). We always like to back up our intuition with data. Our conclusion here is that what has already happened is irrelevant, the only thing that matters is what will happen next. If you think an investment has a higher expected return than your current portfolio, then if your portfolio is in a drawdown is irrelevant. The only thing that matters here is if the new investment will be improve your portfolio, whether it’s higher returns, lowering risk, diversifying or some other positive characteristic.

The Four Horsemen of Investing

We want to talk about two things we think this article gets wrong. The first is that each of the 4 horsemen they talk about (complexity, concentration, leverage, and illiquidity), are not things that should be avoided at all costs but rather things that should be properly managed. None of these things is lethal (for a portfolio) on its own, rather it’s a combination of several that can kill a portfolio. Leverage in particular has a bad reputation, in part because many high profile fund blowups can be attributed to heavy use of leverage. For example, Long Term Capital Management blew up because they were extremely levered (20 to 1) and were trading in illiquid securities with complex instruments. In 1998 the Asian the Russian financial crisis hit them especially hard, and the Federal Reserve had to organize a bailout by large Wall Street firms in order to prevent a collapse in the broader financial market. Many of the trades LTCM did were arbitrage trades, in which they saw mispriced securities and bought the cheap one and sold the expensive one. Since the profits from these individual trades were small, they had to use massive amounts of leverage to earn a return. The problem with leverage is that it introduces path dependency risk. Even if you are 100% sure a trade is going to work out, if you use a lot of leverage, you might get a margin call before the trade plays out. If you don’t use leverage, you can hold on until the trade eventually works out.

The other point we want to make is that financial media only uses returns as the one measuring stick to compare different investment alternatives. However, the objective of any investment portfolio shouldn’t only be to generate the highest return possible. An investment portfolio has to be judged by what the asset owner is looking for. It may be that the owner of the portfolio has a large private business that depends on the global economy doing well. Therefore, they might want their investment portfolio to do specifically well in a market crash. If we were to judge the portfolio solely on returns, we might conclude that there are better alternatives, but that isn’t the objective of this portfolio. Portfolio analysis is much more complex than just looking at returns. Different pieces have different purposes. When analyzing investment options, it’s the same thing. A tail risk fund shouldn’t be expected to perform well when stock markets are booming, but it should outperform in a market crash. Most financial media only looks at returns to judge investment options. And if the last 10 years are the only time period, you’re looking at then the only conclusion would be to invest in the S&P 500 since it seems to never go down (this year excluded). However, this portfolio doesn’t make sense for 99.99% of investors. Look at more than just returns when analyzing investments, look at how they fit into a portfolio, look at when they are expected to do well and when they’re expected to do poorly. And when constructing a portfolio make sure to include assets that will do well at different points in time.

UST Stablecoin Loses Dollar Peg for Second Time in 48 Hours

A couple of weeks ago we joked that there were only two types of stablecoins, those which had lost their peg and those which hadn’t lost their peg yet. Over the last couple of days another stablecoin called Terra lost its peg to the US dollar falling by over 44%. From Twitter rumors it seems that the peg was broken by an “attack”. Essentially somebody put on positions that would benefit from the coin losing its peg and then traded in a way that made the coin drop and lose its peg. Like we’ve written many times before, investing in crypto is the wild west, if you have any crypto in your portfolio you probably have no idea how the different coins work.

Thinking about why people invest in stablecoins is interesting. The entire point of a stablecoin is to maintain a 1-1 peg with a traditional fiat currency. Many stablecoins pay interest at much higher rates than US dollars. For example, USD Coin (USDC) pay 7% annual interest at BlockFi (a cryptocurrency exchange). So, if you keep your money in USDC the best-case scenario is you earn 7%. But the worst-case scenario is that USDC loses its peg and drops a significant amount, therefore wiping out many years of interest earned. It is a completely asymmetric bet, an asymmetric on the wrong side, with limited upside and 100% downside. You can try and measure the risk of these stablecoins dropping but without being an expert in cryptocurrencies and how their blockchains work, it is very difficult to measure this risk.

Private Equity, Anyone?

Private equity used to be reserved for accredited investors. In the US to be considered an accredited investor you need to have either $1M in assets (excluding your house) or an income above $200,000 in each of the last two years and expect to make the same in the current year. This has meant that most investors have not been able to invest in private equity (which may be a good thing!). Typically, to make money in active investing you need to make a right call on the price of something and make it before other people notice. Therefore, you have to put on a trade before other people notice it. Then as other people notice it and start putting on that same trade it will drive the price towards what you expected. Same thing happens in broad asset classes. Typically, when there is a sector of the market or a new asset class that is new, few people will invest. As the asset class gets more institutional acceptance and more people start investing, the early investors will be rewarded. There is a saying that goes that when the shoeshine boy starts giving you stock tips it’s time to sell. Basically, when everyone is talking about an investment, it’s likely the top and it’s time to sell.

It seems we’re at that point with private equity (PE). We’ve been skeptics of PE for a while now, but now it seems everyone is jumping onto the PE bandwagon. From the CALPERS CIO saying that they needed more PE and they needed it now, to new funds being targeted to retail investors. Pension funds are chronically underfunded and with low expected returns, they are turning to PE as a magic asset class that will fix their underfunded status. Now large firms like Blackstone are looking for ways to offer PE to retail investors. This would drive even more money to an already bloated asset class and push valuations even further. This would no doubt help in the short term, but long term means lower returns for an expensive, illiquid, complex asset class which uses a lot of leverage (4 horsemen anyone?). PE is starting to look like the shoeshine boy giving you stock tips…it might be time to sell.

7 Charts for Making Sense of These Markets

This year has been one for the record books. A couple of interesting facts about markets this year:

  • The US stock market is having one of its worst starts to the year. As of this writing, the S&P 500 is down almost 16%.

  • The US bond market isn’t doing any better, US aggregate bonds are down ~10% and 10-year treasuries are down 11%. This means that a moderate allocation is down almost 12.5% for the year.

  • To put these #s in perspective, the during the first 3 months of 2009, the S&P 500 was down 11% but 10-year treasuries and aggregate bonds were down only 1.5% and 2% respectively.

  • Inflation numbers are coming in very hot, with CPI for march at a historic 8.5% year on year. The last time this number was this high was in January 1982 when the CPI came in at 8.4%. However, the difference then was that the CPI rate of change was actually falling since it had been 8.9% the month before.

  • US value is outperforming US growth. Growth stocks are down around 27% while value stocks are holding steady with a loss of only 1%.

Everybody likes to be a Monday morning quarterback, and now it seems that everybody predicted that this was going to happen. However, it is very easy to say this after things have happened, much harder to predict before things happen. And it’s even harder to act on these predictions, since being wrong can cost a lot of money.

Thanks for reading!

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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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