The Ultimate Sophistication

Wild moves in stock and bond prices this year illustrate well the difference between speculating and investing. Individuals and institutions gambling on volatility-related Exchange Traded Notes (ETNs) recently learned the lesson that purchasing a financial contract in hopes that, within a few hours, a particular index won’t move too quickly in a certain direction is not an example of “investing” and can be a dangerous strategy. 2018 thus far has reminded us that when an investment must be described in overly complicated terms, it is probably neither a good, nor sophisticated, opportunity.

An age-old philosophy known as Occam’s razor posits, “when faced with competing options or theories, one should consider the least complicated one.” As background, at the turn of the 14th century there lived a Franciscan friar known as William of Ockham. As any good friar in those days would do—he pontificated and theorized. Although historians still debate how much he is responsible for Occam’s razor, he did write “it is futile to do with more things that which can be done with fewer,” a line that may have inspired other thinkers to expand upon his observation.

The Shortest Distance?

One should not interpret Occam’s razor to mean that simpler things are always better (e.g. unicycles versus bicycles), but rather, when studying various hypotheses, the one with the fewest assumptions is easiest to test and therefore has less chance of error. The argument for simplicity is a time-tested notion. In an interesting publication from the Journal of Business Research, 32 research papers were studied comparing 97 simple and complex methods of forecasting future events. They found that regardless of the forecasting method, complexity consistently harmed accuracy and increased forecast error by 27% on average.1

We think Wall Street regularly violates the spirit of Occam’s razor—and generally on purpose. The latest financial product poster-child was the VelocitySharesTM Daily Inverse VIX ShortTerm Exchange Traded Note linked to the S&P 500 VIX Short-Term FuturesTM. First, note the space required to spell out the name of this product. We will not endeavor to explain all of the intricacies of such a scheme other than to say that it is a promise by a bank (that may or may not be financially strong) that allows intraday speculators to guess at where the volatility of an index (not the index itself) may close. Here are convoluted excerpts from the prospectus for the aforementioned product that recently declined 96% in a matter of days (and was delisted), after going up a lot previously:

The VIX index is a theoretical calculation…the settlement price…is based on this theoretically derived calculation. The ETNs do not accurately provide exposure to the level of the VIX Index…instead the ETNs track an index of futures on the VIX Index. Changes in the levels of the applicable underlying Index…will not necessarily be reflected in the calculation of the applicable Redemption Amount…The Calculation Agents for your ETNs will have discretion in making various determinations that affect your ETNs, including the Closing Indicative Values, the applicable Redemption Amount, the occurrence and effects of an Acceleration Event and the existence and effects of Market Disruption Events…this discretion could adversely affect the value…and may present the Calculation Agents with a conflict of interest.2

What’s In a Name?

Mr. Gobbledy meets Mr. Gook!  All 193 pages of that prospectus were littered with similar disclosures that make the childhood rhyme, “she sells seashells by the seashore” easy to repeat. Aside from the complexity, buried within are warnings that “you are likely to lose part or all of your initial investment” and “investors with a horizon longer than one business day should carefully consider whether the ETNs are appropriate” as “it is likely that you will suffer significant losses even if the long-term performance of the applicable underlying index was in the desired direction.”2 You can’t make this stuff up; it is (buried) there in print!

So who, you may ask, are buying speculative contracts such as this (notice we do not call them investments)? The answer is institutions like Harvard, the Hawaii and Illinois State Pension Plans and many individual investors hooked on day-trading—all of whom seek some “secret sauce,” while either ignoring complexity or believing they understand it better than others.

The recent collapse in these securities reminds us of the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund that brought that firm—and eventually our banking system—to a halt in 2008. As a related aside, we have observed that most over-engineered investment products have code words in their title that should scare an investor away instantly. For the record, euphemisms in the title of a fund that we believe may signal undue risk include words like premium, enhanced, special, alpha, structured, aggressive, inverse, leveraged, dynamic, Bear and Stearns.

So what does all of this mean to Hamilton Point and our clients? Our simple—and we think elegant—approach is as follows: when investing in fixed income, purchase high-quality bonds, with the intention of holding them to maturity, in entities we believe will pay investors back with interest. When buying stocks, select companies that are expected to produce a reasonable amount of excess operational cash for shareholders, relative to the risk we believe we are taking.

Importantly, and in accordance with the earlier referenced academic work, our quality-based investment hypotheses can be tested by our in-house research in ways that we believe have less chance of error. Though we do make mistakes in our analyses, we think the range of potentially disastrous outcomes is mitigated by our relatively straightforward philosophy. Over the long term, we believe the markets will reward this approach, even if markets do not always recognize as much over the short term.

Stay in the Friar Pan

The ETNs that we talked about earlier (along with countless other Wall Street products) failed Occom’s razor, and investors paid the price for speculating in them. Not only were the ETNs complex, they did not even represent an investment in operating enterprises—they were bets placed on where a theoretically-derived volatility index might settle in the future. Honestly, we welcome the occasional meltdown like the one experienced this year, especially when it is related to the unraveling of nefarious Wall Street products and exposes those who trade them.

Leonardo da Vinci, born around 100 years after William of Ockham, captured the same spirit of Occom’s razor, with a quote attributed to him, “Simplicity is the ultimate sophistication.” We feel certain that they both would have appreciated our timeless nod to simplicity herein.

1) Green, Kesten C. and J. Scott Armstrong. “Simple versus complex forecasting: The Evidence.” Journal of Business Research 68 (2015):1678-1685. Print.
2) VelocitySharesTM supplement to the propectus dated March 6, 2014.