Three Ways To Be In Service To the Market

• Posted by DynamicHedge
• on March 2nd, 2016

The constant drone of controversy you hear in the background on active vs passive management and rules-based vs discretionary and how you “outsmart” other investors obscures the fact that there are only three ways to make money in the market: Accept the equity risk premium, provide liquidity, and uncover superior information. All three are actually in service of the market. Understanding that is key.

Accept the equity risk premium (and hold on to it)

It’s difficult to remember sometimes what we’re doing when we buy and sell stocks, particularly if you are a buy and hold investor using passive indexes. As an equity investor, you are taking on the riskiest portion of the capital structure to gain access to the present value of the future earnings of a company. There are logical arguments to be made that equity returns should be lower than debt, but equity returns consistently outperform bonds. The primary reason for this outperformance is the fact that equity investors tend not to look as far into the future as bond investors and have an itchy trigger finger — they’ll sell at the first time of trouble. The technical term for this is “myopic loss aversion.” This constant knee-jerk selling means you can buy consistently for a slight discount, and this discount represents the persistent equity risk premium embedded in stocks. So if you buy stocks passively and want the benefit of the equity risk premium, you need to hold on and sit through the volatility that others won’t to actually realize it. If you don’t have any superior information (more on that later) and don’t hold on for long periods, you’re just doing the same thing that everyone else is doing when they panic and sell: teeing up the ball for the next potential long-term investor.

If you have a pool of capital, you can do very well to bear the equity risk premium and collect the compensation over a long horizon. You can take as much or as little risk as you like. Small and speculative companies are considered high risk, and large-cap stocks with stable earnings usually have a lower risk (all else equal). You can combine different stocks with different characteristics to maximize the potential return per unit of risk. Combining stocks and other asset classes to get the most return per unit of risk in the most efficient way lands your portfolio on something called the efficient frontier. You always want the highest return per unit of risk, so the idea is to find a portfolio that falls on the efficient frontier and select if based on how much risk you can theoretically withstand before you cry uncle (there’s A LOT more to it than that). The risk–return tradeoff is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment. The tradeoff between risk and return (loss) is an immutable law. Those who proclaims they are can get an additional return with no additional commensurate risk are liars, ignorant of the risk, or have a structural transaction in which they have convinced someone else is to bear their risk for them.

Loaning your money to equity markets is providing the world of finance with a service. The faithful service of your permanent capital.

Provide liquidity

Liquidity is the lifeblood of finance, and if you have some to offer when others need it, you will be well compensated for it. One way investors generate liquidity-related returns is by performing market making and arbitrage activities. HFT seems to be a dirty word these days, but when you break it down, HFT is a service to you, called liquidity. Large pools of permanent capital finance the daily global equity transactions in exchange for a small fee in the form of the bid-ask spread. Market making of this variety happens on a vast scale by computers. Speaking of dirty, yes these algos will appear to front-run your buy orders and run away from your sell orders almost every time because they (rationally) try to avoid adverse natural selection. Do you think their owners want them financing informed players trades, i.e. insider information (more on that later)? If HFT runs away from your trades, you should be flattered. The little robots think you’re a better-informed trader than they are.

Believe it or not, providing liquidity used to be an excellent business for even medium sized investors until a few years ago when the table stakes for regular market making went sky high, and the edge got razor thin. As mentioned previously, the reward is always dependent on how much risk you take. When lower risk market making became dominated by computers investors moved to riskier arbs which have higher profit due to less liquidity and more chance of not getting filled on one side. Since arbitrage is often dependent on leverage, one false move can wipe out all gains and more. Unlike passively putting money to work and accepting the equity risk premium, providing liquidity is an active game and you can amplify returns based on how often an opportunity presents itself (exposing you to the same risk more frequently). The availability of liquidity can be a good signaling tool to let you know what kind of returns to expect. This can be used broadly. If liquidity is high, returns will be lower. If liquidity is low, returns will be higher (all else equal).

Another way to think about providing liquidity is through the lens of value investing. Value investors tend to invest in beaten down stocks which are somewhere on the spectrum of “distressed.” The best value stocks are filled with a shareholder base looking to get out for short-term reasons and clamoring for liquidity and continually lowering the price to attract those with liquidity to spare. Value investors that buy these troubled stocks are performing two services; they add liquidity where it is badly needed, facilitating another investors exit. They also receive the usual equity risk premium. In this way, value investors get a double whammy which is part of the edge. The other part is information — coming up.

Uncover Superior information

The market is not a level playing field, and some investors simply have access to better, more timely information than average. Some investors are insiders. Some investors are willing to cheat. Some investors have an army of quants working for them. Information alone is not enough to outperform, but it doesn’t hurt. When investors are talking about ways to outperform the market they are usually trying to use one or more analytical techniques to uncover opportunities more quickly and efficiently than their competitors. The upside of finding such an edge is immense. The downside is that it’s very hard to uncover something truly unique and durable in the market. For most average investors, trying to uncover some new method of market analysis is a waste of time as the competition is just too intense.

Just like the other two, there is a precise relationship between how much risk you take and how much reward is available to you. Gaining an informational advantage is far from costless. On the low-risk side, you or people you hire, can spend hours researching and understanding different companies and businesses to uncover return generating information. The time could be spent on other profitable activities, but it might be a good tradeoff depending on the scenario. Now, take the riskiest proposition, trading on insider information. Insider trading is the ultimate advantage (provided you know how to interpret it) and gives the opportunity to yield near-riskless profits. The punishment, however, for insider trading is severe.

Gathering information with the sole intent of using it to exploit the market may seem completely self-serving. However, increased information introduced to the market is rewarded by the market. Your actions in the market are information in and of itself and can be signaling to other investors. Therefore, acting on a well-informed thesis serves the market by making prices more efficient. And there’s the rub, because acting on ill-informed thesis gives away an opportunity to others.

So that’s it. You can only make money when you provide a service to the market or take risk others aren’t willing to bear.

Any of the investing categories in isolation can be a good option. When a strategy touches several or all of the categories, it will be superb.

Good luck out there.

If you are looking for an informational advantage, Market Memory is a great place to start. You will have to risk some of your time and learn how to use it. I promise, it’s worth it. Send me a message if you need help.

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