Zero Beta

Last week I followed a discussion led mostly by Paul Kedrosky and Felix Salmon on whether analysts should own their own stocks.

From Infectious Greed,

Felix. You argue that analysts shouldn’t own the stocks they cover. I have argued the opposite, so we disagree. Let’s have it out.

The essence of your argument is three-fold:

• Institutional investors ignore analysts’ buy/sell recommendations. It is their analysis that counts.
• Owning or being short the stocks would introduce behavioral biases.
• Analysts can’t pick stocks anyway, so having them own the stocks they cover wouldn’t improve things.

Saying that institutional investors ignore analysts’ buy/sell recommendations is both a broad statement and an untrue one. While some institutions ignore analyst recommendations, many others don’t. Matter of fact, I am familiar with both quantitative and non-quantitative investors for whom analyst recommendations are key factors in their investing. For example, among the best performing factors in some current quant funds’ models is relative changes in consensus recommendations, while the underlying analysis to which you attach so much importance is irrelevant.

It is, in short, untrue and simplistic to say that institutional investors ignore buy/sell recs. There is ample evidence to the contrary, both at quant and non-quant funds…

Kedrosky’s argument goes on to hit all the points but basically they take opposite sides.  I believe however, that this is the wrong argument to have, and the fact that it is being debated takes away from the real issue - that in order to be ethical analysts should also “own” their analysis.  Whether they own the stock or not is irrelevant.

To explain why it is irrelevant, think of the ideal case of an analyst who is not corrupt in any way, owns the stock he or she covers and believes in, and therefore publishes a bullish analysis on it.  The analyst will have a gain/loss from holding this stock if he or she is correct/incorrect and the market moves based first based on the recommendation of the analyst (depending on the analyst’s fame and location), then converges on the fundamentals, which is dependent on something fundamental to the stock, which is the analyst’s job to point out, and been either correct/incorrect in doing so.  Since an ethical analyst can not front run his or her analysis (or should not publish analysis for the benefit of someone who can), and no analyst is really big enough to move a market on its own, the benefits of owning the stock is simply a function of how good their analysis is.  If they are paid based on the quality of their analysis, and how much value they are able to add to clients, the choice of owning the stocks they cover will not really affect them unless their analysis is good.  If you assume it is just random, it will just change their distribution to be “fatter”.  They will benefit more from their good analysis and lose more from their bad analysis as job implications combine  with investment implications.  It is then, merely a decision on how they wish to manage their risk.

Obviously, if the analyst is unethical there may be benefits to owning the stock, but they are still not allowed to trade against their own published analysis, so they personally shouldn’t really benefit from pumping and dumping.  The ethical problems then come in if there is someone or someones in their firm that benefits from a certain analysis being published.  That being the case, the disclosure of positions owned by the analyst serves at nothing else but to add the ability for a skeptical investor to measure the purity of their analysis.  If you see they don’t own the stock you may think they are not believers and sell while in fact they are believers, but know that they have a tendency to get married to things they own and owe it to their clients to stay removed.  If you see that they own the stock you may buy it, but in reality the analyst is a corrupt puppet of the firm and in return for owning a few shares and pumping the stock, they will get a huge bonus from the banking business it won.  If you know nothing about what they own, you will judge solely on the analyst’s current and past analysis and judge his or her worth.  Since whether they own the stock or not is really irrelevant to a good ethical analyst, disclosure of ownership can dilute the value of a good analyst and mask the corruption or incompetence of a bad analyst.

The other point worth mentioning is that analysts should only be responsible to the firm’s clients, since they are the only ones paying for the analysis.  There is a large market effect that occurs when analyst reports are met that deflects obscures the value of the analyst’s research ability.  Analysts’ reports are now widely available and many analysts are like rock stars on CNBC.  Any analyst or firm willing to give their analysis to the general public as well as their clients dilutes the value of their analysis - since it is supposed to be a service to their clients.  I’d be pretty pissed off if I bought a treasure map from some guy for a ton of money just to see that he photocopied it and gave it to twenty people essentially the same time he gave it to me.  I’d wonder who else he gave that map to before me.  I’d feel like I was swindled.  Clients should feel the same way as the analysis is only as good as the ability to take advantage of it.

By giving it to many people who could possibly beat clients to the punch, the analyst is essentially “selling” their analysis to the market.  If you think of a analysis as something with value that describes some way for your clients to benefit from overall market’s error in valuing a certain investment, the only way to own your analysis is to go give it to client with the idea that it will add value to them, and you will realize that value through compensation and future business.  If after giving your analysis to clients you go out and hype it up at the market, then you are immediately selling it and cashing in.  You hope that the market pulls up your client in the short term, and reflects upon you well.  It decouples your analysis from reality and flattens your position in your analysis to neutral.

The only indicator that is important to gauge an analyst is the accuracy of its past analyses.  If an analyst gives price targets based on some time value - its analysis should be released, judged for accuracy, and disclosed only right after the price target time period has passed.  This way the market effect of the analyst is isolated and the accuracy of the analyst is shown.  If an analyst simply provides ideas, methods, and strategies without recommendations, the research should only be released to the general public after an extended period of time, by which the clients can interpret the research and use their own judgement to make investment decisions.  If these were the only requirements the market and the clients could better judge the return on the analysis they paid for - removing the market effect and lookig at the analysis itself.  Since analysts are paid most time indirectly by the clients they provide analysis to, they all have the incentive to be “long” their own analyisis.  Those who perform badly are most likely poor, corrupt, or both.  They also most likely do not own their analysis.  Those who perform well are most likely good, and own their analysis. This is the only thing you should care about, and all this focusing on the noise, such as share ownership is not helpful.

Tags: analyst recommendations, biases, institutions, quant funds, stocks

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I recently accepted a position as an analyst for Yoonew.  If you haven’t heard about them, you should check the site out.  Yoonew is, at its core, a sports ticket futures/options exchange.  While they offer a depth of products, they are best known for their “Fantasy Seats”.  These allow the average fan to buy tickets to the big game (Superbowl, World Series, NCAA Final Four, etc), if their team (or whatever team they choose) makes it to the game.  As you can guess, the creates a much more efficient and free market for these tickets.  Thanks to the growth in information and technology, the ticket industry, as many other industries have in the past, is experiencing increasing transparency and dynamic pricing, and Yoonew will be a very exciting place to be during this period of time.

I first heard about yoonew from a post on All About Alpha and found it to be very interesting.  When I started to look for a new job saw that they were looking for someone, knew where I wanted to be.  For someone whose major interests are financial markets, derivatives, exchanges, web technology, startups, as well as sports, working at Yoonew will be a dream come true.  I’m really excited about it and while for quite some time I was worried it wouldn’t happen, I found exactly what I was looking for.  It is also quite fitting that these products are in fact zero beta assets.

To those of you who responded to my post on looking for a job, I truly appreciate your help and advice, and the response was much greater than expected.

To those who are looking for a job in this market, or may have to soon for whatever reason (especially those in New York), it is quite difficult out there - trust me I know.  Below is some insight from my own process that I think is useful to those who are looking for whatever reason that may be..

1. Don’t get discouraged and don’t settle.  Find a few jobs you will really want and go after them hard.  Many people are playing quantity over quality right now because they are scared, insulted, and/or never really looked for a job.  It won’t work.
2. This is not a seller’s market, and getting worse by the day.  There are tons of people looking for very few jobs - a good portion of which are becoming available because a previously higher paid person occupying was fired so that they could hire someone for much less.  Many positions that a year or two prior someone with a good background, education, and skill set, but little to no experience are being offered at significant discounts in compensation but requiring MBA’s and 5+ years of experience - the supply demand is so skewed that they can.
3. If you wish to look for a job, or are forced to look for a job, EXPECT to take a pay cut - its nothing personal, its just the way it is.  Those who don’t, are going to find themselves unemployed for quite some time and eventually earning something far less than what they “deserve”, doing something far removed from what they want to do. Also, realize that these layoffs should make things like rent cheaper in NY, as demand will dry up and supply hits the market - but it should take some time before it works through (its called deflation).  So a pay cut may be offset by a cost of living cut - don’t dick around looking for a salary, look for a job that you want.
4. Send a Cover Letter.  Your resume may be the greatest thing since sliced bread, but there are so many resumes getting sent, that the easiest way to make the first cut is to take out all the people who didn’t send a cover letter.
5. If you are going to write a cover letter pointing out the obvious on your resume, or give some generic cover letter,  your resume better be good.
6. If on your resume there isn’t at least two of the following words: Goldman Sachs, MBA, CFA, CPA, C++, SQL, or “Willing to Work for CDO’s”, if you don’t plan on sending a really targeted cover letter (something that takes a few hours to write), don’t waste your time sending any cover letter at all.  You can email a resume, but I would almost say that the process of emailing it, and following up on it, along with the rejection that you will probably feel cause that to be a net-negative activity.
7. You are going to find the bullshit on your resume is going to be noticeable and its really going to  stink.  Everybody bullshits on their resume to some extent, and the urge to do so will be greater this time around, as you feel the weight of the competition.  It will only hurt you.  Since nobody wants to take risks and the people who are evaluating your resume are worried about their OWN jobs, and there are many resumes flying around, any resume that is bullshit free will strictly dominate your resume - because its much more transparent.  And when I mean bullshit, I don’t mean lying.  I mean the fluff.  If you were Junior Analyst at Retarded Bank and you write that your responsibilities were way above what a Junior Analyst would do - even though you may have “kind of” did stuff like that, there is someone who had a job that actually did stuff like that.  You are much better served toning down the bullshit as there may be other jobs available, that if your entire resume wasn’t in doubt, you could get.
8. Just because a job is posted, it does not mean that there is necessarily an immediate need to fill it.  Many jobs on these boards are posted new, but have actually been posted and reposted for months to look fresh and stay current.  Many people are looking for this as an opportunity to come across the right person.  If you are not sure right person for a certain job, don’t waste your time taking a flyer.  If you think you are the right person, you better spend a lot of time convincing people why you are.
9. Headhunters may actually blow you off.  They have no incentive on making a “risky” sale at this moment and piss off a client.  They have way too many people looking for way too few jobs.  If they say they’re looking for you, don’t count on it.  They are salesman like anyone else and don’t risk much saying that.
10. Using your network doesn’t work like it has in the past.  Many people are worried about keeping their own jobs and have no incentive to pass on a resume.  The further out you get on your network and the less they know you, the more this is true.  They are not being assholes or blowing you off, they are just either being realistic or looking out for themselves - there is a difference and dont’ take it personally.
11. For many on Wall Street, there are not many great “opportunities” out there.  One opportunity that I saw was in positions that you may have dreamed about doing or would liked to have done, but never had an economic incentive to do because you were paid too much not to for so long.  It is a decent time to make strategic moves with your future in mind, or moves where you are compensated through some intrinsic intangible such as happiness, growth opportunity, work environment, etc.  Right now this is where the value is, as many people have not yet realized that they are not going to make as much as they used to and are wasting time applying for jobs they are not qualifed for because they filter based on salary.  This won’t, however, last for long, so the earlier you realize it, the better you are.
12. You are selling yourself.  Some people who are looking for jobs right now dont’ understand that.  Many got their first job through posting their resume on Monster or their college job board, going to an interview, and then being sold that job.  In most cases this is not happening right now.  Always be closing.

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It is my pleasure to announce that I am no longer an anonymous blogger. I am excited to finally be able to shed the anonymous cloak and finally blog as myself, Justin.  While at first I didn’t mind to blog anonymously, in fact found it kind of cool to be some sort of online “alter-ego”, at the end of the day its much better to be yourself, and I’m finally able to do that.  While I find nothing wrong with an anonymous blog, I do think that they lack an element of personality and interaction that makes them always lacking something.

Thanks again to all my readers who for some reason have put up with some unknown guy’s ramblings for now over a year.  At least now you have a name and face to go along with the nonsense.

Justin

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Yesterday I read through Dash of Insight’s comment on a post last week from Abnormal Returns as well as a older post by Daily Options Report..  It’s a given that when Abnormal Returns writes a post it should always be read as they truely are too few and far between, and I have always found Dash to be a very insightful blog and much different then the econoblogosphere standard, and while I don’t always agree with what he says I always read it.  Anyways I have commented in the past on the nature of the econoblogosphere (see this and this) and enjoy the discussion tremendously and would like to add a few thoughts.

A major theme amongst the articles is the need for a “gatekeeper” as well as the idea that what is most popular is not necessarily most helpful.  First off I believe that Abnormal Returns is the best example of the paradox that arises.  Abnormal Returns is far and away THE best as well as most useful financial/economics blog Aggregator out there.  It is a real shame, but unfortunately Abnormal Returns’ excellence and usefulness cause it to be one of the less valuable of the major Aggs (and hopefully this dynamic can change).  Why is this the case?  Abnormal Returns’ value comes from who Abnormal Returns is and what he or she does.  Every day I begin my journey through the econoblogosphere through Abnormal Returns because I know I am going to get the 10 or 20 most relevant and unique blog articles of that day.  Abnormal Returns has a talent in not finding just what Abnormal Returns thinks is relevant, but what IS actually relevant - and there is a difference.  If you pay attention, Abnormal Returns seems to always have daily and weekly ongoing themes, subthemes and discussions that are seamlessly weaved into the linkfests.  Whether this is intentional or not, it is something that is a unique skill and could not be easily replicated by someone else.  Abnormal Returns is a one of the most significant financial journalists around, but rarely writes anything.  Thus it needs to be independent and objective, and not have ad revenue or be owned by a financial media provider to be successful - a real Catch-22.

The above was not intended to be an Abnormal Returns lovefest, rather to illustrate a much greater point.  You always learn less from those who are seeking to maximize profits, power, or fame than those who seek to grasp and share truth.  There exists a perverse incentive in the market for truth and knowledge, and this is probably more due to the lack of a market for those things (as Dash points out).  Most people don’t seek truth, but seek acceptance.  As someone who hung out with many different groups of people in high school, I would learn much more useful knowledge speaking with some “nerd” from my AP English class on the way to lunch then you would learn from spending years hanging out with the popular kids.  While a few of the “popular kids” were incredibly insightful, they were not valued by the crowd based upon their insight but on their ability to assimilate.  In reality, the irony is the popular kids are by and large the most average of a group of students in many ways and the less popular the most unique.  I’m sure many can both relate to this and attest to its universality beyond the confines of high school.  In fact I believe that popularity can many time cause mediocrity and behind a popular person, artist, blogger, analyst, company, athlete, etc is a very unique person who at one time shared some sort of “truth” and as they became more popular are essentially held hostage by the desire of their followers, who by nature will be much more mediocre, to relate to them.

From the philosphical to the more practical, there is really no easy fix in the investment/econo/financial blogosphere.  I believe that what is interesting is the “bearishness” and many of the arguments that has characterized the rise of the econobloggers has proven to be a truth and has brought many mainstream visitors who in reality are much more likely to be interested in an underlying truth only when it becomes obvious - thus the mediocrity.  The next few years will be interesting to see how the “popularity” of the econoblogosphere manifests itself.  A reader posted a comment on Dash’s article which illustrates this “

If the consumers of this information don’t attach much value to truth and geniune insight, there will be very little incentive for people to produce it.  I also think many people are overlooking the obvious.  In regards to financial advice, what is most popular is rarely, if ever, the most profitable.  Thus, it is impossible to imagine a reality where the most popular bloggers or journalists provide the most profitable and/or helpful information to the masses. An idealist with the notion that it “should” be the other way around, is virtuous in his pursuits but I believe will eventually be disappointed in his results.

Nicholson says it best in “A Few Good Men”:

Tags: abnormal returns, aggs, blog, blogs, consumer, economy, financial economics, financial journalists, gatekeeper, housing, insight, journey, linkfest, media, options, paradox, shame

I came across this interesting article today on crop insurance.  It made me think about the nature of the product and its ties to the commodity markets.

From Bloomberg,

Glen Stenzel’s corn and soybean farm in southwest Iowa is reaping rewards from the highest grain prices the 63-year-old has seen. Rising costs to protect the crops are creating a windfall for his insurance company too.

Premiums paid to crop insurers jumped 43 percent last year to $6.6 billion, while the number of policies declined, according to the U.S. Department of Agriculture. That means Wells Fargo & Co., Ace Ltd. and American Financial Group Inc., the largest providers, bolstered revenue without having to do more work.

They’ve also been lucky, avoiding catastrophes like the 1993 flood along the Mississippi and Missouri Rivers, and the 1988 drought that ruined production in Kansas. In the worst years, claims may cost insurers five times annual premium revenue.

“The thing that’s making the numbers looks so much better on crop insurance is higher grain prices,” said Art Barnaby, 60, a professor of agricultural economics at Kansas State University in Manhattan, Kansas.

Crops that are more valuable need more liability coverage, said Barnaby, who helped develop crop insurance policies in the 1990s. “If you’re a grain farmer or crop insurance company, either one, you’re better off,” he said.

The growth in crop insurance, which has been profitable every year but one since the 1993 flood, comes as most of the U.S. property and casualty industry stagnates. Overall sales fell to $508 billion last year from $512 billion in 2006, according to the National Association of Insurance Commissioners in Kansas City, Missouri. The decline occurred as rates dropped for workers’ compensation, factories and airplanes.

Price Drives Profit

Wells Fargo reported that the rising price for crop coverage drove a 26 percent increase in first-quarter insurance revenue. San Francisco-based Wells Fargo sells policies through its Rural Community Insurance Services unit in Anoka, Minnesota.

“It’s growing in line with the crop prices,” said James Schiro, chief executive officer of Zurich Financial Services AG, which provides reinsurance to Wells Fargo, in an interview yesterday. “As you’ve not had any major crop failures, it’s become more profitable.”

Revenue at American Financial’s crop business climbed 25 percent in 2007 to about $200 million, said Anne Watson, a spokeswoman for the Cincinnati-based company. Carla Ferrara, a spokeswoman for Bermuda-based Ace, and Susan Stanley of Wells Fargo declined to comment.

Crop insurance, started in the 1930s to help farmers rebound from the Great Depression, is subsidized by the government, which sets rates based on commodity prices. The most popular coverage, revenue insurance, was introduced a decade ago to guarantee farmers a minimum payout if prices fall or weather destroys crops.

Insurers haven’t suffered an annual loss in Iowa since 1993 when floods blanketed the state’s grain fields, resulting in claims of $292 million, more than 4.5 times what they earned in premiums, the department said. Premiums paid by farmers rose 64 percent in Iowa in 2007 from the previous year to more than $600 million.“Multiply that by five; they could lose $3 billion in a heartbeat,” said Kansas State’s Barnaby. “I don’t think they fully comprehend how big a loss they could take if we get an ‘88 drought or ‘93 flood.”

After 1993, when U.S. insurers lost more than double their premiums, the worst year was 2002 as a drought in part of Kansas produced losses, according to the Agriculture Department.

“We’re overdue,” said Mike McLeod, executive director of the American Association of Crop Insurers, a Washington-based nonprofit group that serves insurers. “We’ve had an abnormally good run of weather in the last several years.”

First, I find this article misleading for two reasons One, because it really does not make it very clear whether it is aggregate premiums or rates are increasing.  The difference is huge. In reality rates are set each year by the government, and from what I have read they don’t rise that dramatically.  The tone of the article tries to make it look like the insurance companis are preying on these farmers, when in reality they are being told by the government is paying them to sell insurance at set prices and the underlying commodity prices are what is rising.  In addition, they imply that insurers are going to lose tons of money if something happens.  This is a little misleading.  In 1993 there were enormous losses, but that was before the Federal Crop Reserve Act of 1994 which provided disaster assitance through reinsurance.  If anyone is going to lose money under a major loss its going to most likely be taxpayers.

For a company to sell a crop insurance policy in a state, it must agree to offer crop insurance to every farmer in the state at a predetermined rate.  In return, the government subsidizes 30% - 70% of the farmers’ premium payments and provides reinsurance to the companies whereby they are refunded for the operating costs associated with writing the insurance (A&O) and allowed to separate their risks into a fund where exposure is limited and another where there is a greater potential for underwriting gains and losses.  This encourages them to write more coverage than they would if there was no government interference.  If you are interested, this is the Standard Reinsurance Agreement.

The nature of the product is very interesting.  The most popular forms of coverage are revenue based, and from what I have read, the most popular form is Crop Revenue Coverage (CRC).  A CRC policy protects farmers from either low yields, low prices, or a combination of both.  It is designed to be coverage against multiple perils such as bad weather or price fluctuations.  The insured are able to to lock in a predetermined yield (APH) at the higher of the base price ( e.g the average of December Futures in February) or the Harvest Price (e.g the average of December Futures in October).  Coverage can be 50% - 85% of revenues.

Thus, the risk of the insurance company appears to be combination of price and/or basis risk and weather risk. The price component is merely the spread between the base and the harvest price and the insurer is exposed to how much that spread widens by October.  The weather component is the risk that a weather-related event causes a decrease in yield.  In many cases this is accompanied by an increase in price - such as floods or droughts.  In the flood of 1993, losses in output were compensated with increases in prices.  Insurers’ losses were large because they had to pay for the decrease in yield differential in yield as well as the increase in price. Even before you take in account the deal they get on reinsurance, crop insurers are primarily insuring futures price risk.  As I mentioned earlier, a very interesting form of insurance.

This has intriguing implications.  First, this is one of the only forms of insurance that the insurance company can monitor their exposure to some degree in real time.  They can simply follow a 30 day moving average of December Futures.  This I would think would lead to the desire to hedge one’s risk exposure.

If a company puts a CRC policy with CAT in the Assigned Risk basket, depending on the size of the loss ratio, and have an underwriting gain (loss ratio < 100) they retain 2 - 15 % of the net premiums.  If they have a underwriting loss (loss ratio > 100) they retain 2 - 5 % of the losses (which is probably the expected loss due to a catastrophe).  On the other hand, if they place the policy in the Commercial basket, with a underwriting gain they retain 11 - 94% of the net written premiums, and 17 - 50% of the losses.  Therefore, I would think that an insurer put a lot of policies in Commerical basket that they would otherwise have put in the Assigned risk basket into the Commercial Basket they have the potential to earn many more of those premiums, and the loss ratio is determined by the basket as a whole.  I would think after hedging, they could get those suspect policies down to a point at which they may have to pay a few percentage points more if something unlikely occurs, but could reap substantial profits. Also, since the loss ratio of the basket is what is considered in determining the premiums ceded and lost, putting higher loss ratio policies into the commercial basket will get them closer to 100 and a higher retention of gains.  The losses that they have on the individual policies will occur in the basket and the hedges that they have put on accrue in a seperate account.

More specifically, if you assume the insurance takes the price of the base rate as fixed in February, and that if the price falls they will benefit, the insurer is essentially short a synthetic call on the rolling 30 day December Future with a strike at the February base price.  Since the moving average (making the assumption that the T-30 value will fall out) will only be affected by the movements in the latest price for December Futures.  Thus, after February, you could dynamically hedge your delta with futures and possibly your gamma with options. I know very little about commodities so I would not say exactly how I think it would be done - although I have an idea.

I am not sure what actually happens with this insurance in the real world but it seems like a real sweet deal, as there shouldn’t be nearly as generous a  reinsurance policy as they are given.  I find it interesting that many companies first quarter earnings for many of the insurers such as ACE and Wells Fargo’s Insurance division were up tremendously primarily due to crop insurance.  While I don’t think insurance companies are doing anything wrong or unethical - they are going to do what they are able to do. I find it peculiar because not too long ago farmers simply used to hedge themselves in the commodities futures market, and this is pretty much the same thing.  The fact that the crops are insured, would make me think that farmers no longer sell forward as much as they used to - which in turn takes the billions of dollars on the ask side of a order book for commodities futures, and perhaps give an insurer an incentive to place a bid on them.  I would think given the relative large size that farmers make up in the commodity markets, this would cause a material price change, although it could never be proven.  Usually a subsidy has the effect of pushing the price of something down as consumers and producers share the gains from the cost of the subsidy and there is a deadweight loss.  The fact that we are subsidizing insurance on the commodity may infer something completely different.  Since it provides downside protection and still leaves farmers with the upside on the cash market, it may be creating a futures market not really dictated by supply and demand.  The subsidies usually would flood the cash market with too many goods, but if they don’t have to enter the cash market unless its higher than their floor, why would they?  They now have much greater negotiating power because they essentially have eliminated their downside.  At the same time if you have hedge funds trying to speculate in these markets, by tying together the theoretical arbitrage that exists between futures and spot markets, and with less farmers needing to flood the market, then the spot will follow the future rather than the other way around.  Wouldn’t this put an upward bias on the commodity prices?  I’m not sure, but what I do know is that its an interesting insurance product.