Coin of the realm


That Bitcoin, and its ilk, are experiencing a “Netscape Moment” should serve as a cautionary note on many levels to investors. The practical similarities between the web browser Netscape Navigator as an investment, and Bitcoin as an investment are obvious. Netscape made using the World Wide Web practical for the average computer user. Bitcoin is the first application to make blockchain technology accessible for the average computer user. But with technology stocks, it does not usually payoff to be the first person at the party. So, it should come as no surprise if the “Bitcoin Moment” ends badly.

How the web was like blockchain

The World Wide Web was for much of its early years an intriguing idea without any widespread application beyond the military and academia. It took the creation of a universal access tool, initially Netscape Navigator, to make a sprawling, but difficult to access network something everyone could find a use for. Navigator made it possible for anyone to get aboard what is now called the Internet and communicate (email), connect (Facebook), share information (Google) and offer a platform for commerce (Amazon).

Netscape Navigator 1994 IPOLong story short: Navigator launched in late 1994 with an IPO in late 1995 being one of the most successful ever, up to that time. Additionally, Nestscape set what many investors would still consider a bad precedent by also being unprofitable when it went public. Long story short, by 1997 Microsoft’s Internet Explorer was the hand’s down winner in the so-called “browser wars” and Netscape never recovered. In 1998 AOL acquired Netscape. Its fate was the canary in the coal mine.

For our conversation today, let’s sum up the browser analogy this way. When Netscape opened up access to the Internet, few people were thinking about e-commerce or online bullying. The evolution of the Internet browser was trial-and-error in its purest form. Where blockchain ultimately ends up taking us remains unknown and we are still very early on a long journey.

So, what’s up with the futures exchanges?

What grabbed my attention was the announcement of the two Chicago options exchanges now offering futures contracts on Bitcoin. And there is some irony to the fact the contracts can only be bought and sold using dollars – you can’t actually short your Bitcoin collection,BITCOIN-EXCHANGES-RISKS just gamble on its price variations. Yet the speed with which the options exchanges embraced the blockchain left me baffled until reading about a couple of projects MIT is working on in collaboration with two very different consortiums.              Herein might be the next phase of blockchain implementation with the potential for serious impact on the global financial system.

One powerful application of blockchain is to create a viable currency to be shared among fringe economies. Think of Eastern bloc countries like Bulgaria, Romania, Albania and Hungary creating a shared currency for use on par with the Euro and Ruble. Or of the many marginal countries in central Africa, also challenged by failed economies. In theory, the open nature of blockchain ledgers would make it possible for everyone – both inside and outside of the currency network – to see when a government is, for lack of a better term, cheating the system and exclude just their blocks from commercial use. Here, the transparency of an open ledger creates value and stability, making allies of adversaries.

Global Blockchain NetworkAnother interesting idea is using blockchain to create a cryptocurrency tied to physical commodities like gold, oil, sugar or wheat. This would eliminate the necessity of having to price commodities in dollars, Euros or rubles, reducing the amount of friction and cost in transactions by moving toward a true barter system. For international trade, this would be a huge shift in the balance of power away from the major currencies. To my mind, this scenario provides a perfect explanation for the rush to embrace blockchain by the futures exchanges.

Blockchains and Blockheads

First, while not qualified to discuss the intricacies of the blockchain, I do have a firm grasp of the concept. Bitcoin will be discussed here only as an example of how blockchain technology works. However, blockchain is the engine for all of the recent wave of “initial coin offerings” (ICO) and Bitcoin competitors like Ethereum and Ripple. Though ICOs have now been banned in China, the government of Argentina has proposed an ICO to replace its own now worthless currency. And for the truly gullible, many shady companies are using ICOs to raise capital, bypassing any credible oversight and making fraud easy.

Which brings us to a second point which is counter-intuitive. Bitcoins are money. In the final analysis, the goal is to have a currency accepted worldwide that is not regulated and cannot, in theory, be manipulated by governments or central banks. Unlike dollars, Euros, renminbi and yen, there is, in theory, a permanent, public record of every time a Bitcoin is used in a financial transaction. Which can also make its widespread use for illegal and nefarious purposes hard to understand. And if the use of cryptocurrencies for transactions actually takes hold, imagine how big a blockchain could become to manage.

Now, let me make my bias clear. While appreciating the argument of why we should not trust “fiat money” like dollars, Euros and yuan, cryptocurrencies take this concept to an extreme. Because the dollar is no longer backed by a physical commodity – gold – doesn’t mean there are no assets of the United States government to support a value for our currency. Just one example, the value of 52-million acres of national parks on the auction block is worth a lot more than whatever is in Fort Knox. Most cryptocurrencies are backed by no one and nothing. This is what makes the blockchain work of MIT and the futures exchanges so interesting.

Perhaps the most accessible conversations about cryptocurrencies and their potential future are described in the January 2018 issue of Scientific American. 

Gaming the system

The metal found in a dime may not be worth ten cents when melted down,  and the paper a Euro is printed on has no value,Bitcoin Wallet but both are widely accepted and easily used for commercial transactions. To spend a Bitcoin you have to have both electricity and Internet access while still relying on an exchange (like the currency kiosk in international airports) to facilitate a transaction. The word “coin” couldn’t be more incongruous as a descriptor in this instance. That cryptocurrencies are “mined” is an even more egregious misuse of a word to give gravitas to the idea of digital money having some physicality.

So, it works like this. Massive amounts of computing power are necessary to solve cryptographic number puzzles (yeah, it’s a computer game). The prize for solving one of these number puzzles is a unique, one-of-a-kind “block” that is subsequently entered into a massive digital database. Each block becomes a Bitcoin, or whatever the blockchain owner decides – like a share of “stock” in a bogus enterprise. Bitcoins are created and verified solely by raw number crunching. In Siberia (a hotbed of Bitcoin “mining”) you can now buy a home heated by the computers being used to “generate currency”.

The digital ledgers (or databases) belonging to each cryptocurrency are open for anyone with the right equipment to access. When it comes time to make a purchase, or perhaps trade cryptocurrency for old-fashioned dollars, computers work to verify the legitimacy of the block(s) and add this latest transaction to the block’s history without any centralized authority being involved. In theory, blockchains cannot be altered and will exist forever. Massive fraud has recently seen hundreds of millions of dollars-worth of cryptocurrencies disappear making this “fact” suspect as a reality. Assuming your counterparty in a transaction will accept Bitcoin for payment you can pay for a car or illegal narcotics. The average transaction fee of around $30 making buying things like a latte or sandwich impractical. And some vendors won’t accept Bitcoins whose history includes the creation of, or use by, entities known for their involvement in criminal activities.

Finally, if you decide to join the cryptocurrency crowd, all it takes is opening an account online (cash up front) with a Bitcoin exchange and you are given a “digital wallet” for making transactions – pretty much the same way as using a mobile phone payment system. Best guess is that around $8-billion was spent using credit cards to open Bitcoin accounts in the 4th quarter of 2017. It just couldn’t be easier to set yourself up to be fleeced.

What could possibly go wrong with cryptocurrencies?

Quite a lot, actually.

On a practical note, recently one of the Bitcoin exchanges (Bitstamp) saw the value of one Bitcoin go from $17,000 to $19,000 to $15,000 in less than half an hour. One explanation attributed the wild swings to traders in Asia, where it has been suggested that on any given day up to 20% of all Bitcoin transactions are taking place in South Korea. A coin exchange went bankrupt a few of weeks ago in South Korea after being hacked. There is no legal recourse for account holders, they are simply wiped out. And tell me again how you’d feel about paying $30 to use a Bitcoin ATM to get some fast cash?

Perhaps most scary, and telling, is this quote, “A survey of over 200 board-level British executives recently found that while over half of businesses sampled are planning Blockchain initiatives, more than 40% of non-IT/data senior executives admit to not fully understanding Blockchain technology.” In other words, we have no idea what this is, but we want some. APNIC: Don’t Get Caught Up in Blockchain Hype



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Oh time, thy pyramids

Let’s start with a reminder that equities and fixed income instruments don’t respect the Gregorian calendar. Why should it? At what point does the fact that a year consists of about 356 days, and further divided into twelve months of more or less 30 days each, be considered a reason for selling stocks? This is not a concept of particular interest to Mr. Market. It is also a concept that should remain off the radar of investors, especially those with retirement accounts.

A brief history of time for investors

Conceptually, we call the time it takes for the earth to complete a full rotation on its axis a “Day.” The time it takes for the earth to complete a full rotation around the sun is called a “Year” during which period almost 365 days occur. The actual starting point of this cycle began around four billion years ago and as such remains a bit of a mystery.

Retirement not accountable to Egyptian Calendars

That this idea of a year being divided into twelve-month segments that have some kind of significance can be blamed squarely on ancient Egypt. Not only were the Egyptians responsible for the calendar as we understand it, they also suggested a start and finish to the year for help with planning around the annual flooding of the Nile. But they also invented tax collection, another questionable practice (as a side note, they also invented beer as we know it, and I’ve long been suspicious there’s a connection between this simultaneous appearance of beer and taxes). Today, as a recent article in National Geographic demonstrated, religion can also play a role in setting the start and finish of a year; March for Hindus, September for Jews and Muslims.

To tax, or not to tax

In tax-deferred and retirement accounts, no changes should be made just because the calendar says it is December. Or March, or September. Long-term investments are as oblivious to a twelve-month calendar as Mr. Market. As for investment transactions made in taxable accounts, there might be reasons for things like selling stocks to “harvest tax losses” but this often has the feel of market timing. Yes, you can sell a stock for a loss on December 30 and use that credit to avoid paying some taxes on profitable equity trades you’ve made. But why would you sell a stock with long-term potential for a short-term benefit? And if it was a crummy investment, why wait until year-end to sell? Unlike the Ancient Egyptians, you can “tax harvest” at any time. 

The first page of the papal bull "Inter Gravissimas" by which Pope Gregory XIII introduced his calendar.

“Inter Gravissimas”

So please don’t make a bunch of trades in your IRA or 401K retirement accounts because it’s the holiday season. Or because of decisions made by an Italian pope named Gregory in 1582 that subsequently provided the U.S. Internal Revenue Service with a framework for how to start taxing incomes to pay for the U.S. Civil War. Of course, we all know that taxing incomes in 1862 was just a temporary action initiated by Congress that couldn’t possibly endure since so many citizens were opposed to the idea.

What about stock markets next year?

Now, having said all of the above, let’s ruminate on S&P 500 returns for the year that was, and the year ahead. Knowing now that an artifice like the Gregorian calendar doesn’t have any relevance you can confidently declare a better reason for all those December sales of stocks in your retirement account. Everyone knows that after a big year like 2017 – likely to finish the year up around 20% – the next year will likely be not so good. This could be an unfortunate assumption.

As clearly demonstrated by the Boys at Bespoke (highly recommended), the performance of equity markets over time has about the same predictable correlation as flipping a coin; none. In fact, comparing index performance year-over-year is falling victim to the same bias; that Mr. Market has an internal clock and a memory. Comparing 12-month results from December to December will vary dramatically from comparing results from August to August. The S&P 500 had a very good year in 2016, up almost 12%, with most of the gains coming in the 4th quarter. Certainly, a signal to sell going into 2017, right?

As for next year, well, if you’ve built a well-diversified portfolio of indexed funds anchored around a core holding like the S&P 500, your returns are likely to benefit from the fact that markets tend to rise more than they fall. In the final analysis, it’s about building wealth over time, not market timing to get rich quick.


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Foreign Affairs

The Current Status of Foreign Investment

Invest-Notes has always been a big advocate of investing in enterprises operating beyond the borders of the United States. And while the world has not turned out to be quite as flat as predicted during the close of the last millennium, this increasingly volatile terrain remains a viable place to look for foreign investment opportunities. Almost a quarter of my personal retirement accounts are invested in stocks and bonds from non-U.S. companies.

Emerging Markets

Among the sectors that can be found across international equities, the most (in)famous is likely Emerging Markets. The most popular exchange-traded fund (ETF) proxy for this sector is EEM, iShares MSCI Emerging Markets. Up around 35% since the regime change in Washington, DC a year ago, this remains a scary place for many individual investors. Crushed during the market mayhem in 2008-2009, EEM has taken a longer, more volatile route back to a solid uptrend. Which might just make this a time for those without exposure in this space to consider adding some international flavor.

A quick comment before we do some analysis. Early on Emerging Markets was a catchphrase for the BRIC counties – Brazil, Russia, India and China.

Foreign Investment - BRIC Nations Brazil, Russia, India and China

BRIC countries- Brazil, Russia, India and China.

These days Mexico, South Africa and Taiwan also play supporting roles with walk-ons from countries like Turkey, Thailand and the Philippines. All-in, most Emerging Market indexes offer up around 10% of total world equity capitalization making this suitable only as a small part of your total foreign investment portfolio. In my case, 6% is invested in a competitor to EEM, Vanguard’s VWO. Today we’ll compare and contrast these two ETFs with an eye to the future based on some recent events.


While the biggest difference between EEM and VWO is the number of stocks included in their respective portfolios, a quick comparison points up a couple of points to consider:

EEM – iShares Emerging Markets

  • MSCI index
  • 900 stocks with around 9% turnover annually
  • 1.25% yield
  • 27% of the index value is in the top ten stocks, seven of which are Chinese

VWO – Vanguard Emerging Markets

  • FTSE index
  • 4,000 stocks with around 13% turnover annually
  • 2.25% yield
  • 17% of the index value is in the top ten stocks, five of which are Chinese

Is VWO the Better Option?

In summary, EEM is far more concentrated, more exposed to China and offering a smaller yield. All of which makes VWO a more attractive holding using the metrics preferred here at Invest-Notes. But more significant, perhaps, is what the results of the 19th National Congress of the Communist Party of China could mean for investors holding Chinese stocks. The quick take is that President Xi Jinping has centralized his power, and that of the Communist Party, to an extent not seen since Chairman Mao.

Any notion that Xi would embrace free market concepts to advance the Chinese economy has been laid to rest, despite his time decades ago as an exchange student in Iowa. Ever-tightening control of the Internet, silencing of the press and political dissidents, along with stricter top-down management of the economy open up the possibility for government meddling in some of the world’s largest companies. Especially vulnerable are the two major Chinese-based Internet players Tencent Holdings (TCEHY), the largest holding of both EEM and VWO, and Alibaba (BABA) a top ten holding in both ETFs, that could potentially find themselves with a new major investor – the Chinese government. While not inevitable, it is also not an outlier event based on current trends in China. So, if you determine to add some Emerging Market holdings to your retirement accounts it might make sense to limit exposure to Chinese equities by going with VWO.

Low Risk Additions for Your Foreign Investment Portfolio

Finally, for those interested in adding some foreign investment exposure but with less risk, a good choice might be Vanguard’s VEU (8% of my IRA). Sporting familiar names like Nestle, Toyota and Novartis in the top ten holdings, it more closely resembles an international version of the S&P 500 and delivered solid, but less impressive returns this year than EEM or VWO:

VEU – Vanguard All-World ex-US Index Fund

  • FTSE index
  • 2,400 stocks with around 5% turnover annually
  • 2.5% yield
  • 8% of the index value is in the top ten stocks, only one of which is Chinese – yes, Tencent
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Train keeps a-rollin’


With market valuations at nosebleed levels and market sectors like technology going parabolic, it is easy to make a case that a correction must be immanent. This is not a good bet. The current bull market started in October of 2009 and is now the second longest rally in the last one hundred years. Just to be clear, a bull market is a period without any 20% declines. Now lasting almost 3,200 days, we only need this bull to run for about another THREE YEARS to become the longest of all time. Using financial management language, what we have here is a failure to understand Momentum.

In a nod to one of my favorite economists, newly minted Nobel Prize winner Richard Thaler, this current state of affairs shouldn’t be such a surprise. One of the biases he observed is called the “recency effect.” Simply put, we tend to think the future will look like the immediate past. So an assumption that after one of the worst financial crisis in U.S. history people should be fearful of stock markets makes intuitive sense. It would also be wrong. That this bull run has long been called “the most hated rally in history” tells us more about human behavior than how to successfully invest our money. Just ask the folks who have been waiting since 2010 for a market correction to start investing in stocks again.

Okay, then what do we do now? Think about diversification outside of indexed funds like ETFs, even as they remain our preference as the primary investment choice for individual investors here at Invest-Notes. As discussed previously, the idea that ETFs are in a bubble, or will lead to weird price distortions or even a market collapse are just wrong-headed. But history has demonstrated pretty impressively that buying equities when valuations are high tend to mean subpar returns over time. This is where the idea of adding some individual stocks or narrowly focused ETFs might make sense for adventurous investors.

That there are specialty ETFs almost sure to fail spectacularly shouldn’t be a surprise. There are ETFs holding the stocks of Nigeria or Egypt that have lost a quarter of their value over the last three years. And if you bet on gold miners or master limited partnerships (MLP) during this same timeframe there are ETFs sitting on losses of up to 90%. Of course anyone reading this blog should know better than to even think about an ETF called ProShares UltraPro Short Financial Select Sector (FINZ), down over 40% so far this year, just as in many past years. Conversely the plain-Jane financial services indexes (like XLF or VHF) are up over 15% year to date.

Which makes for a nice segue to offer an observation about a possible investment opportunity. In August of 2016, a change was made to indexed financial services ETFs, like XLF and VHF, for the first time since 1999. No longer included with banks and their ilk, Real Estate Investment Trusts (REIT) now have their own index. A detailed explanation can be found here:

“The Difference Between Banks and Buildings”

The quick take is that previously about 20% of financial index funds were composed of REITs that provided the bulk of the dividend income generated by these ETFs. The assumption at the time was that bank-only ETFs would offer lower dividends and more volatility when the REITs were spun off. As it turns out, 2017 has proven a challenging one for REIT-themed ETFs, like VNQ or ICF. Despite a big spread between the dividend yields (REIT = 4.5% while Banks = 1.5%) the REIT ETFs are mostly lower than at the start of the year, underperforming bank ETFs by a significant margin since their Independence Day.

Another curious result of this separation of banks and buildings is their seemingly inexplicable lack of correlation. As the Boys at Bespoke have discussed recently (, highly recommended), there are asset classes that move in tandem and others that move in opposite directions. A quick example of this is the impact of rising interest rates on two asset groups that wouldn’t normally be thought of as behaving similarly. Yet both utility company stocks and long-term bonds lose value as interest rates go up. So when (not if) interest rates finally start climbing, having invested in these types of stocks and bonds will provide very little safety despite the diversification normally associated with a stock/bond mix.

When comparing a list of 18 popular asset groups (bonds and indexed ETFs, but also oil, gold and Bitcoin), the two assets most likely to go in opposite directions on most days are the REIT and Financial Services indexed funds. As noted by Bespoke, just a year ago they were traded as one asset. This suggests that REITs could provide some valuable diversification if financial equities begin to lose some of their recent altitude. The caveat here being that rising interest rates tend to boost bank stocks while often pressuring REITs.

However, it is just possible that recent headlines about the death of physical retail outlets – versus the online variety – is greatly exaggerated. This red herring obfuscates the fact that most income-producing real estate is not shopping malls – office spaces, warehouses, data centers, apartment buildings, manufacturing facilities, hotels, gas stations and convenience stores – suggesting that the recent underperformance of REIT ETFs might be an opportunity to add both value and income (the 4.5% dividend) to a portfolio at decent valuations.

While I don’t currently own any REIT ETFs, VNQ is on my radar and starting to look interesting. As a side note, over 10% of my personal IRA is in individual REIT stocks that I have owned for over a decade. That the bulk of my personal assets are real estate investments also explains why I have not been in any hurry to add real estate exposure through these new ETFs. But that might be changing.

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A Happy Anniversary


Ten years ago today the first Investnotes was sent by email to a handful of family and friends. In 2010 my good friend Rob Simons gave me a WordPress blog site, set-up and ready to go, as a birthday gift. There has since been over 400 postings on investing, jazz and art.

Here for all to see are my missteps, misguided trades and boneheaded commentary. But also a few solid suggestions and nuanced observations that when embraced by readers delivered real value for the time spent reading these musings.

Thank you for choosing to join me on this journey of discovery, as well as for your many comments both good and justly critical. Below is the first missive to appear as what is now Invest-Notes. Leaving this post unedited has been the most difficult task of the last ten years.

10/16/07 #1

Investing is not a zero-sum game. All the talk about “beating” the averages serves only to distract from the point, which is to generate a meaningful return on your investments while minimizing any risk of significant loss. What someone else makes is irrelevant as long as you can achieve the goals you’ve set based on your needs and circumstances. You don’t have to “beat” anything over time to create wealth. It is also a fallacy that someone else must lose money for you to profit. So what that someone sells you a stock that then goes up. What if that investor had been holding the stock for years and finally cashed-in for big, long-term capital gains? In this scenario one person has exited a position profitably as another enters the same position favorably.

In his otherwise excellent new book “A Demon of Our Own Design” Richard Bookstaber makes the assertion that when hedge funds win, it is because someone else loses. But he then contradicts himself during a fascinating discussion about the primary purpose of the market being to provide liquidity. Equities, for example, are bought and sold not because of economic news (the Efficient Market Hypothesis), but because someone needs money to take a vacation or buy a new home. Conversely, investment firms and mutual funds receive money that must be invested in a timely fashion. This idea of the market as an entity intended to monetize investments means that as long as the reasons for ownership of an equity are influenced by matters not pertaining to the business of the enterprise then it is impossible to assume that an investor has either won or lost in any given transaction.

Whatever your financial goals, follow your own instincts, not those of people who might view the world differently than you do. And don’t get distracted by what other people claim to be achieving. The only thing that really matters is the value of your assets when you need them.


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The Jazz of Investing

Frankly, it’s a fool’s errand to try and decide when is a good time to buy or sell equities based on movements in the stock market. Yes, valuations appear stretched and the recent, relentless upward trend in most market indexes would argue for caution. But this same comment could have been made repeatedly since the market bottom in 2009. A tired old quote is worth a revisit, “The market can remain irrational longer than you can remain solvent.” Or, put more bluntly, nobody has any real insight into what the market is going to do next. The only sensible choice is always to stick with your original investment plan. And if you don’t have a plan, then don’t do anything until you commit to one.

Almost a decade ago Lewis Sanders of investment firm AllianceBernstein made an intriguing observation, “The principal dynamics in the world’s capital markets revolve around a tug-of-war between feeling secure and making money. In the end, the feelings generally win out.” Around the same time a hedge fund manager (whose name is not in my notes) said in a Bloomberg interview that his only trades consistently making money were the painful ones. Buying stocks that are out of favor, avoiding the “hot investments” of the moment and having a plan that you stick with is not just difficult, but is indeed painful.

Looking back to 2000 there were many competent fund managers and investment professionals who underperformed the market during the dot-com bubble. Warren Buffett in particular came under withering criticism for being too old to understand the value of technology stocks. Yet it was the investors, like Buffett, that stuck to what they knew and had the discipline to execute on their strategies, even in the face of public ridicule, that avoided being burned in the subsequent crash. Probably worth noting that Berkshire Hathaway (BRK.A) hit a dot-com bottom of $44,000 per share in February of 2000. It closed yesterday at $278,670 per share.

For those of us who saw our 401K plans become 201K plans during the market mayhem of 2009-2010 the pain lingers. But a refusal to panic enabled disciplined investors to subsequently enjoy one of the biggest bull market runs in U.S. history. If you were buying stocks in the summer of 2009 you were considered an idiot. Today you are a genius for being so insightful at that time.

So all this helps to explain the tendency for emotion to win the day rather than reason. Research has demonstrated time and time again that most investors tend to sell their winners too early (because it feels good to make a profit, any profit) and then hold on to losers (because to sell is to admit that we were wrong, and no one likes being wrong). Having the conviction to avoid these common, painful mistakes requires discipline and the work necessary to fully understand not just what you own, but why you bought it in the first place.

Yet the Big Decision each of us must ultimately make is whether or not to be an equity investor at all. There is no shame in admitting that any loss is too much to bear. Or, that having to make decisions about how and where to invest money we have worked very hard to earn is just too painful, even with professional help. Let’s face it, most investors are not particularly successful anyway. There is nothing wrong with simply socking money away in bank CDs or U.S. Treasuries (the “but what about inflation” caveat notwithstanding, or particularly relevant recently). For most of us, that we routinely spend less than we earn will be the driving factor in creating wealth over time.

Finally, a quick thought about investing strategies derived from the musings of jazz great Miles Davis. Don’t laugh, Davis was making over $200K annually back in the 1960’s when that was a lot of money (his New York City brownstone, Maserati and full-length snakeskin coats weren’t paid for with credit cards). Davis once said that, “If you play a note you didn’t intend to play, what determines whether it sounds like a mistake or a moment of inspiration is the note you play after it.”

Buy a stock; hold the stock, sell the stock or buy more of the stock? Only with study and practice can we become good enough investors to know what note to play next.

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Sake and CRSP

The question came from a good friend in the asset management business over a cup of sake. Talking about a presentation to his firm from Blackrock, one of the biggest ETF/Mutual fund companies in the world, he had been surprised by a trivia-like data point, “What is the percentage overlap of ETFs in the small cap space between Blackrock and Vanguard?” I guessed 80%. The correct answer was less than 10%. What?

Adding to our ongoing conversation about the importance of ETFs in the portfolios of the individual investors who enjoy reading Invest-Notes, this new data point is worth discussing. BlackRock offers the iShares Russell 2000, IWM. For no particular reason I assumed that the Russell 2000 index was the defacto choice for the biggest ETFs since it also tends to be a commonly used benchmark for performance. Vanguard uses CRSP for its small cap fund, VBR. I’d never heard of CRSP.

In last week’s Economist, there was an interesting article on the growing clout of companies that provide the indexes used to create exchange-traded funds. The article did not mention CRSP, even though there is now about $225Billion worth of indexed funds using CRSP as performance benchmarks. Who are those guys?

The Center for Research in Security Prices (CRSP), originated at the Booth Business School at the University of Chicago. So as we’ve talked about things like market capitalization (VOO versus RBC) being a driver in ETF composition worth thinking about, it might just be that the index used for portfolio composition is even more important. Who knew there were so many?

Tools like Morningstar allow for a quick look at the key components of ETFs, with the idea that an investor can make a quick – and easy? – decision on where to put their money by contrasting their differences. In reality, it becomes much more complicated when competing indexes determine the portfolios of ETFs claiming to track the same market sectors. An example of how this is supposed to work, is here:

For starters, there are also small cap funds from iShares, Charles Schwab, WisdomTree, DFA, and others. While some characteristics are easy to understand such as a tilt toward value or growth stocks, more difficult to quantify are factors such as how the portfolios are regularly rebalanced. Important because there are many thinly traded stocks in this space. Or, in this case, the criteria for the composition of the fund’s holdings.

In the case of CRSP, to be included in its small cap index a stock must be smaller than 85% of all other U.S. stocks, but bigger than the smallest 2%. Vanguard’s offering, VBR, consists of around 800 stocks with the top ten holdings only accounting for 5% of the total value of the portfolio. By contrast, iShares IWM holds, well, the 2,000 individual stocks that make up the Russell 2000, where less than 3% of the fund’s holdings are in the top ten. This makes a side-by-side comparison of the top 50 holdings in each fund mostly useless. Other than seeing clearly the lack of overlap in the two funds, each list consists of names that will be unfamiliar to most equity enthusiasts.

Ultimately, the safest course to pursue in such muddy water is to focus on fees. VBR has an expense fee of just .08%, handily beating the expense ratios of most other small cap ETFs where fees range from .20% to over .5%. And the performance has been pretty solid as well. I have about 5% of my personal IRA in VBR.

Finally, it should be noted that this has not been a stellar year for small capitalization stocks, their biggest siblings putting in a much better performance recently. Which might lead a savvy investor to consider adding some ETF exposure to the small cap space while prices are not as expensive as other sectors of the market.

And for any fans of Miles Davis out there, check out a new Jazz-Notes.

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The numbers say that it is so

For the last few months there has been lots of talk about the size of equity markets – specifically the dramatic drop in the number of publicly traded companies. The always interesting Jason Zweig wrote a series of articles on this topic appearing in the Wall Street Journal during spring. One of my favorite resources, Bespoke Investment Group (, highly recommended) has done analysis confirming the reality of the dwindling number of companies available to us individual investors for purchase. Another way to look at these factoids is how they support the case for using indexed funds, specifically exchange traded funds (ETF).

As Alice mentioned in wonderland – a fair comparison for equity markets we’ll argue – the beginning is a good place to start, so it is worth noting that from 1926 to 2015 there have been a total of 25,782 companies available for purchase through a brokerage account. Yet the truly astounding fact is that over this 90-year period, only 30 stocks have been responsible for almost a third of the total returns accrued to stock investors. Since it is pretty much impossible to determine in advance what stocks will outperform over time, best bet is to hold a broad basket of equities and to do so at the lowest possible cost.

Jumping forward and looking at just the last 20-years, in 1996 there were 7322 publicly traded companies, a number that dropped to 3,671 at the beginning of 2017. Putting this in a slightly different context, in the lifetime of the Internet (Netscape went public in 1995!) the number of choices available for stock market investors has dropped by almost half. Of those companies now gone from the equity markets, one third went out of business (perhaps the recent obsession with retailer’s current bout of “Death by Amazon” is just part of a longer running trend). An argument can be made that a smaller pool of investable equities offers more opportunity for holders of ETFs.

Okay, now let’s look at our favorite proxy here at Invest-Notes for equity markets, the S&P 500. As a quick reminder, the S&P 500 is an index of 500 (mostly) large cap stocks that are used to measure the overall health of the stock markets.  By contrast, the Dow Jones Index has only 30 stocks attempting to do the same thing. Only as companies are bought or go out of business, the S&P replaces them with existing equities to ensure a constant count of five hundred. Again, by contrast, the Dow makes changes to their index on an annual basis making it less valuable when looking at long-term trends in its portfolio.

Over the last ten years, the S&P has seen 129 companies go out of business and currently has 72 stocks that are trading at prices lower than they were in 2007. While big technology stocks have been responsible for a significant percentage of the gains this year, most stocks in the index are having a good year. The strength of market breadth (the number of stocks hitting new 12-month highs versus the number hitting new 12-month lows), confirms this is not a rally dependent on just a few big winners, an idea that seems to be making the rounds. Owning an S&P ETF (like VOO or RSP) has been the best bet for most investors for the bull market that began in 2009.

Perhaps the most startling number is how many private asset management firms have at least $100,000,000 in assets under management – around 3,900. This means that today there are more companies telling people how to invest their money than there are public companies to invest in. There were just 750 advisory firms of this size fifteen years ago.

Finally, there was a recent article in the Financial Times using information from the U.S. Federal Reserve to demonstrate that since 1960s the single largest purchasers of common stock – the stuff we buy in our brokerage accounts – are the publicly traded companies themselves. This helps explain why the huge shift of funds belonging to individual investors moving into exchange traded funds at places like Blackrock and Vanguard have not had an outsized impact on market prices – and are unlikely to for the foreseeable future.

Markets go up more often than they go down and the various asset classes tend to rotate over time as market leaders. So it appears reasonable to assume for the foreseeable future that individual investors are best served by maintaining portfolios anchored by a few broad ETFs that can capture gains while limiting losses. For the more adventurous investor, adding a few individual stocks with strong fundamentals and a healthy dividend is also an option, but should remain a small percentage of assets.

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Berkshire versus Blackstone

A lot of pixels have been lit up here at Invest-Notes discussing Warren Buffett, Charlie Munger and their amazing enterprise, Berkshire Hathaway (BRK.A and BRK.B).  While the B-shares have been added over time to most of the portfolios I manage since their creation in 1996, the case to be made for adding shares now is more uncertain than usual. There is no doubt BRK will continue as a viable entity after Buffett and Munger have left this mortal coil. Still, even Buffett has suggested that at this time a better option for smaller investors might be an indexed fund of the S&P 500 instead of BRK.

There are two reasons for considering this advice. First, Buffett and Munger have yet to announce a formal succession plan despite their respective ages (87 and 93), so when the inevitable occurs we should expect a knee-jerk sell-off by the public. Which, following Buffett’s own advice, would likely mark the next really good buying opportunity of BRK shares. Second, BRK pays no dividend (though it prefers to own stocks that do), which typically account for a significant portion of total long-term returns for most equity investors. That the A-shares cost $256,000 each and the B-shares around $170 can also be intimidating for individual investors.

The benefit of having BRK in an investment account – beyond being associated with one of the best investing minds ever known – is that the size and breadth of its holdings allow for meaningful diversification. BRK functions more like a mutual fund or ETF than a typical publicly traded stock, offering the opportunity for individual investors to participate in ownership of asset classes not available through equity or bond holdings.

One alternative investment worth considering is Blackstone Group LP (BX), which I have been adding in modest increments to a couple of accounts since the beginning of the year. Uncommon among other publicly traded asset managers because BX also invests across four primary asset areas; real estate, credit, private equity deals and hedge fund-like investments. Interestingly, this means BX doesn’t just invest on behalf of its clients (mostly institutional) and collect management fees. BX participates as an investor with its own profits creating additional revenue streams. And like the Berkshire Boys, senior managers are major owners of BX shares. The recent dividend yield of over 6% is also compelling, though due to the quirky nature of many BX deals the annual yield over the last few years has vacillated between 3% and 9%.

If all this sounds complicated, it is. Most investors know of BX only tangently through the controversial cofounder and CEO, Stephen Schwarzman. Unjustly in my opinion but a potential positive for investors, BX has suffered from Schwarzman’s reputation as much as BRK has benefited from Buffett’s.  Started in 1985 and taken public in 2007, during the financial mayhem of 2008-2009 BX executed on Buffett’s dictum to buy when blood was in the streets brilliantly. Today, BX employs some investment strategies pretty much unknown a decade ago. This makes some investments hard to understand and others potentially requiring decades for a payout.

Additionally, there is another important reason the stock has remained so long under the radar. BX is structured as a limited partnership that brings tax complications and accounting issues such as K-1s. This also makes owners of the stock unitholders instead of shareholders, giving senior management pretty much complete control of the company. Though this lack of investor influence applies equally to owners of B-class Berkshire shares.

A final reminder however that this is uncommon fare and BX is probably not appropriate for most individual investors. There’s quite a bit of risk and much of it is not easily discernable. Yet the concept is important because we tend to think of stock and bond investments in fairly narrow terms. With stock, we own a piece of a business, while with bonds we are lenders to a business. ETFs, indexed and mutual funds tend to own a variety of assets, but almost always in the form of equities and fixed income instruments.

Equities like BRK and BX own stock in other companies (like a mutual fund or ETF) but also own many businesses outright (privately held companies not publicly traded). They both make direct loans and provide variable financing mechanisms while simultaneously owning traditional bond portfolios. BRK is a major player in the insurance industry, BX is an innovator in real estate investments. In summary, BRK and BX offer a unique and typically overlooked opportunity for the adventurous investor.

Note: I attended the annual meeting of BRK a few years ago and wrote a two-part article on my experience and impressions, links below. There’s new stuff in Art-Notes, too.

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Cigarettes and soda pop

Serendipity is a beautiful thing. The recent sell-off in the technology sector made for a perfect demonstration of why seemingly arcane subjects like the capitalization weighting of stocks within exchange traded funds matters. There have been a couple of days lately where S&P 500 indexed funds – which contain the exact same stocks, but in different proportions – saw their performance bifurcated. Meaning, one ETF went up, while others declined. All this is explained in the post below this one.

So, now we’re going to talk about an adjustment in sector allocations that I made about a month ago inside a couple of IRAs. First, I am not suggesting you make this shift in your personal accounts. Second, please note that one reason for making these changes was purely emotional.

For me, one of the more confusing designations is the distinction between Consumer Staples versus Consumer Discretionary. A comparison of these two sectors using Vanguard ETFs helps explain the good and bad of augmenting a pure S&P 500 ETF with additional holdings. VCR is a consumer discretionary EFT with 374 individual stocks, though the top 10 holdings comprise 50% of the total valuation. VDC is a consumer staples ETF with 107 stocks and the top 10 holdings representing a whopping 60% of the fund.

My confusion revolves mostly around why any individual stock is considered a “staple” as opposed to a “discretionary” choice that consumers can make. For VDC (staples) the largest position at 10% of the fund is Proctor & Gamble (PG). With 65 consumer brands, twenty-one that each generate over $1-billion in annual sales, most folks probably need something from their product lines (laundry, baby care, feminine care, and grooming). But the other four stocks in the top five holdings, comprising a third of the entire fund, are either tobacco companies or soft drink manufacturers. How cigarettes and sodas can be classified as “consumer staples” elude me completely. An additional holding is Molson Coors Brewing. While beer strikes me as a perfectly acceptable daily requirement, it is safe to assume most people would disagree.

For VCR (discretionary) the largest holding is Amazon, weighing in at 12% and Home Depot a distant second at 6% of the fund. That Home Depot provides more products necessary for day-to-day living, as a home owner or a renter, than a brewery or cigarette vendor seems to be stating the obvious. Another top five holding is Disney (DIS) and lots of people like cartoons, Star Wars and theme parks.

Now, a quick interlude focused on the S&P 500, the favorite proxy for U.S. equities here at Invest-Notes. The stocks included in the S&P are, mostly, the largest and most respected companies in the U.S. However, smaller companies tend to outperform large cap(italization) stocks over time. But as a group smaller cap stocks tend to be more volatile, and hence riskier for individual investors. Sector funds can provide exposure to smaller companies while increasing exposure to the core holdings of pure S&P funds.

In May I sold all of the VDC funds in two IRAs and redeployed the proceeds into VCR. Here is a quick summary of the reasons that drove this decision. Understand that this list gives the conclusions of my thinking, not the information that underpins these statements.

  • Diversification is better achieved since VCR has over 370 stocks and VDC only 107
  • Individual equities in VCR are more appealing based on current consumer trends, like the shift toward online purchases (Amazon), increasing home ownership (Home Depot) and a preference for experiences over stuff (Disney)
  • Personally, I don’t want to own businesses that hurt their customers – tobacco and soft drinks
  • As for beer, I’ve been a longtime owner of Heineken stock and will remain so
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