Accidentally Laundered
Vol #109: December 8th, 2022
Not many people do the laundry by accident.
I’ve left more wool items in a hot dryer than I’m willing to admit, but I’ve never put a load in during a blind fit of propriety. Cleaning up is fighting back against entropy, it requires energy and intent.
To launder also means to conceal the origins of a pot of money. Even less likely to happen by accident. Truly scrubbing funds of their source requires jumping through a lot of hoops, more than just leaving your Venmo transactions over $600 unreported.
Dishes don’t get done on their own, and money doesn’t grow on trees. While a windfall inheritance or the devilishly lucrative stock option package often look like “accidental money”, there’s only one sure fire way to achieve whatever your definition of success is. That’s rolling up your sleeves and taking an honest shot at your best work.
Alas, valiant efforts can and will fall short. Much as we try to prevent it, shit happens. Prudence and diligence minimize the whoops factor, but across the spectrum of simple and complex problems, the unexpected occurs both more frequently and more significantly than we expect. This is partially human error, and partially the result of the tools we use.
Humans start to build systems to solve simple problems. Basic systems naturally evolve into complex systems, and develop a gravity of their own. As these systems get increasingly convoluted, systems theory tells us that unintended consequences are de rigueur.
Externalities are a necessary bi-product of getting things done. Individual tolerances for breakage may vary, but as Murphy told us long ago, if something can go wrong it will. This is especially true in finance, where competition will eat your fat finger for lunch.
Fortunately we have champagne to celebrate for the fact that not all side effects are undesirable. The legend of Dom Perignon discovering sparkling joy is slightly embellished, but whether it was a monk or an Englishman who first found bubbles, they were delighted to be drinking from the stars when they opened their bottles the following spring.
The traditional method for making champagne involves leaving yeast in the bottle after the wine has fermented, creating a second fermentation where carbon dioxide gas is released. This happy accident was discovered because the cold cellar temperatures of northern France (err, England) halted the initial fermentation that autumn, to be thawed out months later for round two.
As with champagne, it is with investments. It takes a long time to know if you’re on the right track, and there may be burst bottles and other confusing signals along the way. Dom Perignon’s ultra premium P3 offering sits in the cellar for over 25 years before release, with the bottles rotated by hand every few days.
In your face accidents are obvious. Texas hedging is the scourge of distracted options traders. This is when you sell calls, and instead of buying 100 shares of AAPL, you sell 100 shares. Your mistake gets called out immediately and you have to work out of twice as many deltas- which are inevitably trading at a higher price.
Quick and clear signals are enviable, even if it costs you a couple nickels up front. More often there are layers of processes and systems that shade nuance on the absolute truth. Throw in a loop of non-linearity with a dash of stochasticity, and it’s difficult to tell what is signal and what is noise. Time reveals everything, but he’s always too late.
With investment and portfolio management, understanding what’s going on is hard enough. To appreciate if this is within expectations or how it impacts your end goal is even harder. There’s no such thing as a free lunch, but you might be able to get your laundry done on the house.
A big red delta offness is a welcome relief compared to the fermenting risks of poor allocation decisions buried under layers of cellar cobwebs. We operate in a probabilistic world, making judgements under uncertainty, where even no decision is a decision. In order to make these choices, we have to rely on whatever information is available and hope we’re able to reasonably process the facts.
How we dose this information is as important as its content. The message lies in the medium and impacts how we interpret meaning. The systems and processes that are built to regulate the flow of information and offer windows of opportunity will have consequences for our allocations.
As the end of the calendar year approaches, we’re getting to the wrap up and recalibrate stage. 2022 will soon become summarized by a few bullet points, and when father time exits stage left to welcome Baby New Year, the new course is charted.
The end of a month, quarter, and calendar year marks an important milestone for managers and allocators alike. Whether you’re on a quantitative rebalancing schedule (e.g. a target date fund or a flavor of 60/40) or you take a more qualitative approach to tallying your bags, most investors are making some allocation decisions this time of year.
There’s a lot riding on those data points that are headlining your decision making process. If the S&P 500 closes down 13% on the year (approximately where it was going into December), does that fully grasp the pain many people were feeling when we were down 23% in October? Does it need to?
The interval at which we observe a process has a powerful impact on how we perceive changes in the subject. For tick scalpers who are dialed into the depths of stock tweets, every point up or down is an emotional rollercoaster. Most people don’t need or want this, and there are good reasons why it’s advisable to look at your brokerage statement less frequently than you do. Transaction costs are saved, and rash impulses are tamed.
For public equity investments, it’s pretty easy to know exactly how much your position is worth. Anything that fits into a standard brokerage account - stocks, bonds, options, and futures - all have mark to market values that change daily. For better or for worse, you can know your net worth at any given point.
As we move out the liquidity spectrum, things get valued less frequently. The price of real estate holdings can be estimated by what comparables are trading for, but coming up with the NAV for a real estate fund is an intensive process that results in a best efforts estimate. Private equity gets even more nebulous as investments may lack cash flow, and are built only on market consensus.
The reasons for quarterly or annual valuations of privately held assets are practical. It means you can spend your time on improving or finding new opportunities rather than just valuing them. Disclosing less frequently will also mask the true dynamics of ownership - and maybe that’s a good thing. Does getting a monthly Redfin estimate really change your finances?
By only periodically revaluing their book, managers can practice “volatility laundering.” Cliff Asness of AQR has been highlighting the effects of this since as early as 2019. Over the last several years there’s been an increasing move into private investment vehicles, and with it the consequences of this system and structure - some of them good!
The happy accident of volatility laundering is that it forces investors to sit on their hands. Particularly when combined with gated or extended redemptions, the investor is forced to look on a longer time horizon. Some are even consciously paying a premium, either in fees or access charges, to get a bound up in this Ulysses pact.
Asness summarizes his thesis, “you pay (accept a lower return) for good things, like managing emotions, you don’t get paid (ie, get a higher return) for accepting illiquidity.”
The idea of a liquidity premium gets turned on its head here. Private investments have historically been thought of as delivering excess returns because of the opportunities locked up capital can access. It turns out a major feature is the locking, not the access.
While they sound designed for the General Partner’s benefit, there’s a net positive to Limited Partners being restricted by gated exits and periodic disclosures. The benefits of keeping people from making bad decisions about their money outweigh the costs of keeping them from making smart decisions. Hold your cynicism until you look in the mirror.
If narrowed choice frameworks help us perform better in some dimensions, then we must also consider the other spin cycles that quarterly laundering performs. It logically follows that your decision will come shortly after you get these details, and the new allocation is very dependent on prices at that specific time. There’s a lot of really good research about rebalance timing luck - particularly by Corey Hoffstein and co - but a salient point is that it’s luck. This can work for or against you.
Part of the reason that we only rebalance periodically is transaction costs, but there’s logistics and simplicity too. A perpetual rebalance also limits the benefits of letting your winners run. The optimal frequency lies somewhere between “one big one every year” and “on every market tick”.
As with tax loss harvesting or target date funds, I’m confident that soon algorithms will help deliver more nuanced positions. This could be the laddering of options positions across the term structure, or splitting rebalances across parallel cycles. The benefits of portfolio adjustment can be separated from the decision making process of allocation changes.
You won’t read this in any book on portfolio management, but savvy investors are increasingly finding that done right, less can be more, and omission can be a blessing.