May 2022

ONE MORE THING...

  • El-Erian: Thoughtful commentary on the Neutral Rate

  • El-Erian: Not-so-thoughtful statistical innumeracy

  • Gas fees

  • More crypto sinking references

  • The new Dr. Doom


Robinhood Discipline

It takes discipline to stick with one’s strategy when seemingly everyone else is making bank.  Think back to the meme stock mania of early 2021, when far out of the money calls expiring within days were (often enough) wildly profitable.  The fear of missing out (FOMO) is real, so retail investors - with wallstreetbets “emoji research” in hand, piled in.  Plenty of market veterans, myself included, warned that those late to the party will be left holding the bag.  

Well, now we know just how expensive that bag was.  Here’s Bloomberg’s Vildana Hajric with Mom and Pop Investors Took a Billion-Dollar Bath Trading Options During the Pandemic:

 

Researchers Svetlana Bryzgalova, Anna Pavlova and Taisiya Sikorskaya estimated that retail investors lost $1.14 billion trading options from November 2019 to June 2021, assuming a 10-day holding period. Trading costs ate up an additional $4.13 billion.

Trading costs cited by the researchers may not have been easy to discern by many at-home traders. Platforms like Robinhood revolutionized so-called zero-commission trading -- they route trading orders to market-makers like Citadel Securities or Susquehanna, who then pay the brokerages for the orders and, in return, provide cheaper trades for the Robinhood clients. 

The no-fee trades lured a lot of new clients onto Robinhood and others. But the average bid-ask spread in options with less than a week to expiration is a “whopping” 12.3%, the LBS researchers found. The average quoted spread of retail trades across all maturities is more than 13%, compared with 11% for the overall market. Therefore, they might have underestimated the indirect trading costs in the options market, the researchers wrote.  

 

When you pay $4.13 billion in trading costs to lose $1.14 billion on those trades, that’s a losing game.

 

“The past 17 months has been an incredibly trying time for the firm and you, our investors,” founder Gabe Plotkin wrote in a letter to investors. “I have given everything I could, but more recently that has not been enough to deliver the returns you should expect. I now recognize that I need to step away from managing external capital.”

 

Prior to Plotkin’s closing announcement, Ted Seides wrote this nice analysis aptly named The Melvin Dilemma, including:

 

“Melvin’s opening salvo was one of the worst looks for the hedge fund industry since the financial crisis. Eschewing its deal in place with investors, Melvin offered to continue managing capital only for clients that erased its existing highwater mark. The firm offered modest concessions of slightly reduced fees, slightly better liquidity, and slightly lower assets. The proposal optimized for Melvin’s incentives and put its interests ahead of its clients.

 

Later, Seides addresses the investor psychology along the lines of my analysis last month, in particular the breach of trust when a manager proposes resetting an investor protection like the high water mark and the unsettling thought that will always be in the back of their minds - if the new fund experiences losses, will he propose the same reset again?

 

On the other hand, let’s assume an investor believes Melvin can return to its prior winning ways with a reduced fund size. In that case, the investor may have to reconcile conflicting views on the importance they place on partnership and alignment of interest. After a quarter century in the investment management business and a few hundred podcast conversations, I hear repeatedly that character is the most important aspect of manager selection. Those who profess to care most about the people they choose to partner with will have to make peace with Melvin’s instinctive response to its dilemma.  Allocators often only learn about true character during times of great success and great failure. When Melvin soared, it made a seemingly straightforward portfolio mistake of mismanaging liquidity and grew unbounded. When it faltered, it initially put forth a Faustian bargain for investors. If the cycle plays out again, would an investor be surprised if a different investment blind spot arose in the good times or if Melvin put itself first when times get rough? The choice these investors make will shine a bright light on what they really care about – is it the partnership with the manager that matters, or just the net returns?

The decision is likely an easier one for prospective investors. It’s hard to envision that someone on the outside watching the drama play out would choose to engage a manager with highly volatile returns that kept incentive fees from the good years and considered recutting its deal with investors after the bad ones. Melvin will be hard pressed to raise new capital for a long time to come.

 

We now know, that’s exactly what happened - fund investors fled and prospective new investors passed, leaving Plotkin no choice but to step away from managing investor capital.  

Elon joins the active vs passive debate

In the context of railing against Tesla’s removal from the S&P 500’s ESG index, Elon Musk took sides in the active vs passive management debate: 

 
 

Indeed there will be a shift back to active management - when active management reclaims the net-of-fees performance advantage from passive management.

Taking the other side, here’s Warren Buffett in Berkshire’s Annual Meeting earlier this month: Give Your Money to 'Monkeys Throwing Darts,' Not Financial Advisers 

 

“It’s amazing how hard people make what a simple game this is,” Buffett said. “It’s too much to expect of human nature for people to explain that they aren’t really adding any value to what you can do by yourself. I hate to use the example, but you can have monkeys throwing darts at the page and, you know, take away the management fees and everything, I’ll bet on the monkeys.” 

 

Elon Proximity Metric revisited

Last November in One More Thing, I wrote:

 

Quiver Quantitative tackles the Elon Markets Hypothesis.  I will follow and report back on this novel metric’s performance, stay tuned.

 

Matt Levine of Bloomberg’s Money Stuff newsletter has written extensively about and coined the Elon Markets Hypothesis, which basically states that things become more or less valuable based on their proximity to Elon Musk.  The mere mention of a company in a Musk tweet sends those company’s shares soaring.  Lose favor with Elon, your shares will crater.  It’s not just companies either - Musk has tweeted frequently about Dogecoin, and for one notable example Dogecoin’s value spiked 14% after this tweet depicting a Dogecoin storm’s “inevitable” takeover of the global financial system.  

Christopher Kardatzke at Quiver Quantitative geeks out on this kind of stuff and built an Elon Markets Hypothesis tracker to test the hypothesis.  So me being me, I set a 6 month calendar reminder to revisit this tracker and see whether the hypothesis withstands the test of time.  Now, 6 months is a short time span, but 6 months is not nothing either.  

Here’s a 6 month chart of the top 7 stocks with respect to the “Elon Proximity Metric” , excluding Tesla (TSLA), against the SPDR S&P 500 ETF Trust (SPY): 

 
 

Source: Interactive Brokers, Likely Capital Management

5 of the 7 are ahead of SPY over the past 6 months.  Not bad!  

ONE MORE THING…



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