March Members Newsletter

Posted by Alex Frey (@alexhfrey )

The thing that I enjoy the most about investing is the excuse that it offers to learn as much about the world as possible.

Placing any kind of investment by necessity involves making a prediction of one kind or another about the future of the world. So it stands to reason that the better you understand the world you live in, the better off you will be. Since nobody can ever say that they perfectly understand the world that we live in, there is never a reason to stop learning.

One of the new topics that I have most enjoyed learning about lately is bitcoin. I wrote about it once before, but I will give a brief introduction now for those that missed it. Bitcoin is essentially two things: it's a new protocol for sending digital assets, and it's a stateless form of currency. A "bitcoin" has no physical representation: it's just a sequence of 1s and 0s. The technology development required to do this on an open network, without any chance counterfeiting or double-spending, involves a non-trivial application of cryptography.

When I wrote about it previously, the value of a bitcoin had gone up by a factor of ten times over the timespan of a few months. Since then, it is down significantly.

The latest event to send the "crypto-currency" tumbling was the failure of what was once the world's largest bitcoin exchange, Mt. Gox. Mt. Gox served two main roles: it allowed people to trade government-backed currencies like the dollar in exchange for bitcoin, and it held clients' money (both dollars and bitoins) for them.

When dealing with bitcoin, the latter function is particularly important because since your bitcoins are merely a set of 1s and 0s, you need to take proper security precautions to prevent hackers from accessing them and stealing them (though the bitcoin protocol itself has never been hacked, many people have had the "wallets" that they store on their individual computers stolen -- and there is no way to get them back once they are gone).

The best way to protect your "wallet" (which essentially contains the very long and random passwords that you need to access your money) is to store it on a device that is not connected to the internet. This is known as "cold storage", and it is what Mt. Gox claimed to be doing with the vast majority of the bitcoin that it held on behalf of its customers. A wallet that is truly in "cold storage" should theoretically only be able to be stolen if the attacker is able to both a) obtain physical access to the device and b) overcome any passwords or encryption on the device.

But a couple weeks ago, Mt. Gox begun to have difficulties in processing the withdrawals that its customers were attempting to make from their Mt. Gox accounts. And last week, they formally shut off their exchange and declared that they were entering the Japanese version of bankruptcy.

Since then, it has been speculated that some 700,000 bitcoins -- currently worth almost $500,000,000 -- have somehow 'gone missing' from Mt. Gox. It is not clear whether these bitcoins were "hacked" and stolen (this seems impossible unless the Mt. Gox "cold storage" was not actually cold), or if Gox may have lost the "passwords" to the bitcoins, in which they would still be there but be inaccessible to anyone, or if the whole Mt. Gox endeavor may have been a ponzi scheme from the start (ponzi schemes are frauds where a front man uses contributions from succeeding groups of customers to cover withdrawals from earlier customers... until they at some point decide to run off and take the money with them).

Either way, Mt. Gox is and will continue to be a fascinating story of greed, intrigue, and mystery. I look forward to watching the movie version sometime soon.

So what does this have to do with investing?

First of all, let me be clear that we are not adding "bitcoin" as an asset classes to our portfolios just yet. And I am not suggesting that you should run off and put a high percentage of your net worth into crypto-coin (though in full disclosure, I am an owner of some bitcoins, and I'll probably buy some more shortly).

But in addition to being an interesting and potentially highly impactful new financial technology, bitcoin also offers a test of how well we understand our current financial system. Shaking up some of the pieces a bit can make it easier to go back and make sure that we understand first principles of how our financial system operates. And that's something that everyone has a reason to pursue.

Unfortunately, many financial journalists have been failing this test.

Specifically, let me focus on one question: in what ways is the failure of Mt. Gox similar to, and different from, the failure of Lehman Brothers that is thought to have precipitated the worst stage of the financial crisis of 2008?

The financial news media has definitely picked up on some of the similarities. Both events were big. Lehman had nearly a trillion dollars in assets and liabilities when it went under; the 700,000 bitcoins thought to have been lost by Gox represent more than 5% of all the bitcoins in circulation. Both created existential concerns about the larger financial ecosystem too. After Lehman, banks became less willing to lend each other money; after Gox, various media outlets have proclaimed the "death of bitcoin."

But as tempting as it is to explain Gox as another Lehman, the analogy is actually horribly inaccurate on a number of dimensions.

For all of its problems, Lehman was never a case of fraud, theft, or "misplacement," but instead a somewhat predictable result of the financial system that we live in.

Lehman's problems were two-fold: it had borrowed an awful lot of money in order to make investments, and many of the investments that it made were in sub-prime loans and other kinds of complicated mortgage instruments that were rapidly deteriorating in value as a result of the housing crisis that had started in 2007.

A company that borrows 30 times as much money as it initially has is said to be "30-1 levered." The thing about 30-1 leverage is that if the value of your assets falls by more than an average of 3.3%, you are bankrupt, since your equity will be more than entirely wiped out.

But the immediate thing that pushed Lehman into bankruptcy was not a solvency crisis, but a liquidity crisis. Here's the difference: you are insolvent when you owe more money then you will be able to pay back, you are "illiquid" when you cannot make a payment on your debt (even if you may have the money to do so in the future, or in a different account that you cannot access right now).

Because Lehman used short-term loans to buy illiquid and long-term assets, it faced a constant need to rollover its debt. On the other side of those short-term loans were mutual funds, money-market funds, and other investors. Investors in short-term debt stand to gain very little in exchange for risking large sums of money. In normal times, they do not mind because these loans are seen as very low risk. But when investors start to question whether the entity that they are loaning money to is even solvent, and when they then start to question how many other people are going to start asking that same question, this chain can start a run on the bank. Even though Lehman was not a bank in the classical sense of the world, what killed it was very much still a run on the bank. Everyone knew that Lehman might have $30 billion on hand in liquid cash, and need to rollover $200 billion in short-term debt. Nobody wanted to be the last lender out the door. So nobody lent. So Lehman collapsed.

Mt. Gox, by contrast, was (at least supposed to be) running a full-reserve bank, meaning that the company was keeping a bitcoin on hand for every bitcoin that it lent out. If it was actually doing what it was supposed to be doing, it should have been entirely immune from a similar kind of "run on the bank" scenario. And there was no reason it should have been subject to a liquidity crisis.

This distinction is doubly important when looking at the wider implications of each failure. Thus far, the Mt. Gox problem has been relatively contained to Mt. Gox. No other bitcoin exchanges or "wallets" have gone under, and even the dollar price of a bitcoin has recovered since the event. This stands in direct contrast to the Lehman bankrtuptcy, which quickly lead to difficulties at just about every major financial institution, which in turn ultimately culminated in government bailouts.

The Lehman crisis spiraled because in a highly leveraged fractional-reserve banking system, there is a clear mechanism for liquidity crises to spread, even to solvent institutions that may have done nothing wrong. This is because in a fractional-reserve system, no bank (and this includes investment banks and commercial banks) has enough funds on hand to pay back nearly everyone that has entrusted it with their money. So if you as a depositor begin to fear that other people might en masse start to demand their deposits back, then you have an incentive to do that exact thing yourself -- before the bank has given away all of its money. Runs on the bank are contagious.

Not so in bitcoin-land, where fractional-reserve banking has not yet been developed.

Of course, in our world we now have the FDIC and the Fed that serve to minimize this problem. By guaranteeing all deposits up to a certain level, FDIC reduces the chance of a collective stampede of people out the door. And by being ready to lend to solvent institutions that may be facing a liquidity crunch, the Federal Reserve plays an important role as a "lender of last resort."

But these guarantees don't come for free. The explicit cost of the programs is borne by taxpayers, who are the people that ultimately pay for them (in one form or another) if they are used.

A more important cost though may be implicit -- both programs create a kind of "moral hazard." Since banks know that the government will be there to protect them when things go bad, they are able to run their businesses in a riskier and perhaps less responsible way then they otherwise would. And because consumers know that their bank deposits are protected by FDIC regardless of whether or not their own bank is even solvent, they have far less of an incentive to do business only with an institution that they trust. This can lead to an increase in debt levels system-wide, and a greater chance of crashes like 2008.

Ironically, the moral hazard created by one government program (FDIC), needs to be minimized by other government regulations. And that is why we have bank examiners, strict rules on leverage, and a host of other regulations. If we're going to socialize the costs of bailing out banks when they make crazy bets, then we all have a vested interest in ensuring that they aren't making crazy bets in the first place.

Lately there has been talk that bitcoin needs to be "fixed" by more regulation. But whether or not this happens, it ignores the fact that the bitcoin economy currently lacks many of the same initial conditions that create the need for regulation in the first place. Notably, in bitcoin-land there is no fractional-reserve lending, very little or no leverage, and no federal deposit insurance.

Many commentators are showing that understanding of bitcoin is the least of their worries: they need to understand the world that we live in first.

Beginner's Corner: The Term Structure of Interest Rates

This month we tackle an intimidating topic: the term structure of interest rates.

Way back in August, I discussed Treasury Bonds and interest rates in general terms. At that point, I said that the yield to maturity that is quoted on a fixed-income investment is equal to the compounded annual return that you would earn if you held the bond to its maturity. So a 10 Year bond that yields 2.7% will guarantee you a 2.7% a year (before-inflation) return if you hold it for 10 years.

All else equal, higher yields are better than lower yields.

But the yields of bonds will vary based on credit quality of the issuer (how likely the issuer is to meet its promise to return your money), and on the term of the bond.

The "yield curve" is a graphical representation of the term structure of interest rates that is derived from looking at the yields of US Treasury bonds expiring in different years.

As it stands today, here are the yields that you can get on bonds of different maturities: - One Year: .12% - Three Year: .69% - Seven Year: 2.13% - Twenty Year: 3.31%

So how are the rates determined? The short answer is supply and demand. Bonds are traded on an open market, and the prevailing interest rates will reflect whatever figure is required to create an equal number of buyers (akin to lenders) and sellers (akin to borrowers).

However, the Federal Reserve can greatly impact the rate that prevails. Partly through buying and selling Treasury bonds, the Fed sets the shortest-term interest rate at whatever rate it wants. It controls "the short end of the curve."

It does not overtly control longer-term rates (though with the current quantitative easing program it is purchasing billions of longer-term bonds every month, which takes a significant amount of supply off the market), but longer-term rates will still move to reflect the market's expectations of future Fed policy.

This is an important point to understand. Let's imagine that you know that you will need money two years from now, that a one-year Treasury goes for 4%, and that a two-year Treasury goes for 5%. Let's assume the Fed sets the one year rate. You should purchase that two year Treasury at 5%, unless you think that in a year's time the Federal Reserve will have raised the one year rate to more than 6%. In this case, you would be better off buying a one year Treasury and just rolling it over in a year.

If every investor is performing this same calculation, then the market's consensus expectation of future Federal Reserve policies should be incorporated into the current term structure of interest rates.

In other words, the Fed may only control the short end of the curve, but by broadcasting their future intentions to the market, they can impact interest-rates at every maturity.

So here then, is an intuitive explanation for the current yield structure. Because we are (still) living in the aftermath of a credit crisis, the Federal Reserve currently has set short-term rates to 0. This keeps the short end of the curve down.

Longer-term rates are higher because the market is expecting that, over time, the economy will return to form and the Fed will raise rates. This creates a "positively sloped" yield curve. If the market comes to expect that the Fed will keep its rates low for longer, then long-term interest rates will come down. If investors start to anticipate that the Fed may raise rates sooner than they had previously expected, then long-term rates will go up.

Model Updates

The model has been re-balanced as of March 3. This is the second month in a row that the model changed enough to trigger our re-balancing. While this is somewhat unusual, it is explained by some relatively large movements. This month, the model is shifting more into stocks. Since the end of January the stock-market has gotten over a bout of turbulence and once again trended higher, while bond yields have dropped (which makes stocks look more attractive in comparison). 

You can rebalance your portfolio with the help of the cloning tool, or view the latest portfolio holdings on the 'holdings' tab of the portfolio page

New Policy on Model Updates

We are changing the policy on model re-balances slightly. From here on, we will update the model on the website after the close of the last trading day of every month.

However, we will only send an "rebalance alert" when the model changes by a substantial enough amount that we feel it is worth it to you to place a trade (we have a "threshold" that we apply). Previously we had only updated the model when it met this threshold.

The advantages of the new approach are: 

  • You can always log onto the website and see an up to date version of the model.  
  • New subscribers will never get into a situation where they buy a portfolio one day and then have to immediately rebalance the next, because the model has changed.  
  • You will still be able to minimize unnecessary transactions by only making changes when we send out a rebalance alert. 
  • If you would like to make changes every month, and aren't paying that much for the trading costs, you now have the opportunity to do so.

When we report performance numbers every month, they will assume that you rebalance whenever we send a rebalance alert.


The following table shows the performance of the IvyVest model vs. the neutral portfolio. Results prior to 2013 should be interpreted as "in sample" backtest results. Results for five years and longer are shown in annualized terms. 

Model "Neutral Portfolio"
1 Month 3.75% 3.73%
YTD 2.19% 3.30%
6 Month 9.93% 8.96%
Since Jan 2013 11.52% 8.89%

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By Alex Frey