The following is an excerpt of Grant Williams' free weekly newsletter "Things That Make You Go Hmmm..." Click HERE to subscribe
"Let's Play Money Making Game." - The Legend of Zelda
"Reality is broken. Game designers can fix it." - Jane McGonigal
"Prepare for unforeseen consequences." - The G-Man, a character in Valve's 'Half Life: Episode Two'
Allan Alcorn is hardly a household name – with the exception perhaps in the Silicon Valley area of Northern California. Alcorn was born on the first day of 1948 in San Francisco and has remained in the Bay Area his entire life. He attended UCal Berkeley, graduating in 1971 with a BSc in Electrical Engineering and Computer Sciences and went to work for a company called Ampex.
Back then, Silicon Valley was a small place and interconnectivity between the pioneers of the computer industry was inevitable (in fact, Alcorn was ‘the other guy’ in many early meetings as Steve Jobs and Steve Wozniak demonstrated their prototype Apple I) which is how Alcorn ended up working for Nolan Bushnell and Ted Dabney at Atari in 1972.
Under Dabney’s direction, Alcorn turned his mind to an area in which he had no previous experience – a new phenomenon called ‘video games’ – and was tasked with writing the code for what he was told was a project for General Electric but that was, in actuality, just a means to give Alcorn some experience in writing a video game:
(Wikipedia): Bushnell … asked Alcorn to create a simple game with one moving spot, two paddles, and digits for score keeping… Feeling the basic game was too boring, Alcorn added features to give the game more appeal. He divided the paddle into eight segments to change the ball’s angle of return. For example, the center segments return the ball a 90° angle in relation to the paddle, while the outer segments return the ball at smaller angles. He also made the ball accelerate the more it was returned back and forth between paddles; missing the ball reset the speed. Another feature was that the in-game paddles were unable to reach the top of screen. This was caused by a simple circuit that had an inherent defect. Instead of dedicating time to fixing the defect, Alcorn decided it gave the game more difficulty and helped limit the time the game could be played; he imagined two skilled players being able to play forever otherwise.
Three months into development, Bushnell told Alcorn he wanted the game to feature realistic sound effects and a roaring crowd. Dabney wanted the game to “boo” and “hiss” when a player lost a round. Alcorn had limited space available for the necessary electronics and was unaware of how to create such sounds with digital circuits. After inspecting the sync generator, he discovered that it could generate different tones and used those for the game’s sound effects. To construct the prototype, Alcorn purchased a black and white television set from a local store, placed it into a 4 foot (1.2 m) wooden cabinet, and soldered the wires into boards to create the necessary circuitry.
And so, on a cheap black and white TV set, was born a true gamechanger in every sense of the word: Pong.
(For those amongst you born of the ‘videogame generation’ who have never seen the glory of Pong, click HERE and bask in what we children of the 1970s called ‘cutting edge entertainment.' The very fact that this video clip is over 2 minutes long and has over half a million views is proof positive that nostalgia for a forty-some-thing truly knows no bounds)
In the wake of Pong, video game development took off and over the next 5 years, games such as Hunt The Wumpus, Maze War and Zork became familiar to the more tech-savvy teen but, in 1977, the singularity of videogames allied to the fact that a deluge of Pong clones flooded the market led to the collapse of the industry as manufacturers were forced into slashing the prices of their systems and RCA and Fairchild cried ‘uncle’, abandoning their video game consoles. But from the ashes of ‘Pongageddon’ rose the phoenix that was Taito’s Space Invaders and, after its false start, the video game boom was well and truly off and running.
Asteroids begat Pac-Man and the revenues generated by arcade video games hit billion in 1981 (.3billion in 2011 dollars even with the CPI running at under 3%) before peaking in 1982 at bln (.5bln today, but who’s counting? – John Williams, that’s who) which was more than Hollywood box office (bln) and music sales (bln) combined as game designers found their stride. After a brief downturn in 1983-4, the advent of the first real home gaming consoles in 1985, when Nintendo’s lovable plumber Super Mario became a massive worldwide hit, was the moment when the videogame industry became an unstoppable juggernaut.
Videogames increased in complexity from Legend of Zelda to Final Fantasy to Warcraft to the Sims as increased computing power, better graphics, realistic sounds and designers pushing the boundaries with each new release combined to make games ever more complex and ever more challenging until, in the mid-90s, the ‘Quake Engine’ was written that would become the base architecture for a generation of first-person shooter games (FPS).
About now I can sense many of you are saying to yourselves “he’s REALLY lost it this time. Where the hell is he going with THIS one?”, well for those of you who have stayed the course, we will leave the videogame industry here, in the mid-90s, for the time being (we will return to it later), as it gets ever more complex and travel a little way back in time to turn our attention to the American and Philadelphia Stock Exchanges in 1989 and the advent of Index Participation Shares (IPS).
Unlike FPS, IPS were nice and simple.
The advent of ‘portfolio’ or ‘program’ trading which became popular in the late 1970s and early 1980s, allowed managers to trade an entire portfolio (which often consisted of every stock in the S&P500) by placing a single order with a brokerage house. The launch of an S&P500 futures contract on the Chicago Mercantile Exchange had provided an arbitrage between stock and futures and Exchanges For Physical (EFPs) allowed for positions in stocks to be exchanged simply and easily for positions in futures contracts.
The increase in this kind of activity generated a strong desire for a vehicle which enabled smaller investors to trade in similar fashion in large ‘baskets’ of stock and one of the first such products to achieve that aim were IPS.
Their introduction was not without conflict though:
(Omniglot): The Index Participation Shares were a relatively simple, totally synthetic, proxy for the Standard and Poor’s 500 Index. While Index Participation Shares on other indexes were also available, Standard and Poors 500 Index Participation Shares were the most active. They began trading on the American Stock Exchange and the Philadelphia Stock Exchange in 1989. Index Participation Shares traded with a level of activity that showed significant public interest, in spite of a lawsuit by the Chicago Mercantile Exchange and the Commodity Futures Trading Commission, which charged that Index Participation Shares were futures contracts. As futures contracts, they would be required by law to trade on a futures exchange regulated by the Commodity Futures Trading Commission, not on a securities exchange. In spite of the cloud cast by this litigation, Index Participation Shares volume and open interest began to grow.
The Index Participation Shares were, candidly, much like a futures contract; but they were margined and collateralized like stocks. Like futures, there was a short for every long and a long for every short. Index Participation Shares were carried and cleared by the Options Clearing Corporation and they provided a returned essentially identical to the long or short return on the underlying shares in the index with an appropriate quarterly credit for dividends on the long side and a debit for dividends on the short side.
So far so good, but these simple instruments were found, by a Federal Court in Chicago, to be illegal futures contracts and ordered they be traded on a futures exchange or not at all.
They chose not at all and investors had to liquidate their positions. This was the first time these ‘simplified’ products ended up creating unforeseen losses for investors; it wouldn’t be the last.
It wasn’t until 1993, however, that the idea of a simple, tradeable index proxy gained real traction and, for that, we have Nathan Most and Steven Bloom to thank, for it was they who developed the Standard & Poor’s Depositary Receipts (SPY), an Exchange Traded Fund that would once again attempt to replicate the performance of the S&P500 in one simple, easy-to-trade vehicle. The ‘Spiders’ were launched in January 1993 and would go on to become the largest ETF in the world (currently, their market cap stands at 5.6bln).
And so, from a rather complex beginning, the ETF market began to take the opposite path to that of the videogame industry as the simplicity inherent in being able to push a button and buy an entire index in the correct weightings became catnip to investors and led to an ongoing effort to simplify investing in general by providing one-stop shopping for anyone with an idea, no matter how broad that idea may be.
The SPY begat the MidCap SPDRs and, at the same time as the ‘Quake Engine’ in all its ground-breaking technological magnificence was being unveiled to the videogame world in 1996, the Barclays World Equity Benchmark Shares (WEBS) were being rolled out to equity investors in an attempt to reduce complexity by allowing people to invest - with just the click of a mouse button - in exotic faraway locales they might not be able to find on a map and would most likely never visit. The WEBS (later renamed iShares) were (and are) a series of ETFs designed to track MSCI country indices around the world and open up foreign markets - with all their local complexities and idiosyncrasies to a generation of daytraders.
Now, I understand the usefulness of these tools for many investors, but the net effect was that a man in Des Moines, IA could now wake up one morning, read a story in the newspaper about something that happened in Taiwan, for example, and decide to ‘buy’ Taiwan by going long the EWT ETF which, according to Bloomberg:
...seeks to provide investment results that correspond to the performance of the Tai- wanese market, as measured by the MSCI Taiwan Index.
Investing distilled to its simplest form.
From country-tracking ETFs the traveling circus moved to sectors as State Street introduced the ‘Sector Spiders’ in 1998 which tracked the nine sectors constituting the S&P500 Index and, later that year, the DIA (or DIAmonds as it is colloquially known) gave gamers investors the means to buy or sell the Dow Jones Industrial Average. The following year, months before the NASDAQ bubble finally burst, the QQQQ (‘cubes’) NASDAQ-tracker ETF was launched.
After beginning at a country level, ETF issuers narrowed the focus of their products - to indices and to sectors, but then, a curious thing began to happen as it became apparent that, in what had become known as the ‘videogame age’ (a term that bizarrely implies dumbing down in an area that has done nothing but get ever-more complex over the years) ETFs were succeeding in sucking in huge amounts of investment dollars while they found ever-simpler ways to express often quite abstract ‘views’.
Perhaps unsurprisingly, the providers of ETFs began to look for new ways to simplify even complex ideas in an attempt to attract the relatively easy money that seemed to flow into their products and so they began constructing ETFs that would make it possible to express a more broad idea through one easy purchase or sale. This led to commodity ETFs that allowed the investor to take a view on such things as oil, precious metals or soft commodities as well as ETFs that focused on Treasurys, high grade corporate debt and even junk bonds.
From there, the ETF industry exploded as more and more complex products were created - paradoxically with the intention of simplifying the investment process. Think the S&P is going lower? Well why not buy the proShares Short S&P500 ETF? Have a feeling in your gut that High Yield bonds are where the action is but don’t want to take the time and trouble to do the necessary reading and investigation required to find the best-value credit? No problem at all. Just buy the iShares iBoxx $ High Yield Corporate Bond ETF. The guy you buy your bagel from in the morning said something about ‘Asia being where all the smart money is going’ but you’re not sure exactly what he meant? Easy. The BLDRS Asia 50 ADR Index ETF will give you exposure to a group of 50 ADRs of Asian companies trading in the US. Sorted.
Newly-provided with easy, simple ways to express the concept of an idea, investors grew hungry for more and when we talk about ‘investors’ and ‘more’ we are never very far away from the ‘L-word’; Leverage.
If you want to be long the Dow, well you’d obviously LOVE to be DOUBLY-LONG, surely? Well there is a vehicle that will notionally give you 2x the performance of the Dow Jones Indus- trial Average (though in practice, the tracking of these instruments only really makes them capable of potentially performing as advertised over very short timeframes. No matter - I’m sure it’s in the small print somewhere). Have an urge to be double short copper? Check. 3x short Natural Gas? Bingo.
There are now over 1,400 ETFs in the US alone holding over trillion in assets (chart, below) and there are no signs that the pace of increase in this number is going to slow down any time soon. In fact, in the five years to December 31, 2011, Exchange-Traded Products (ETPs) have attracted more than half of all US fund deposits and, according to Yahoo Finance, the future is decidedly rosy:
(Yahoo Finance): According to McKinsey & company, over the last ten years, assets in ETFs have expanded over 30% annually, compared to a 5% to 6% growth in mutual funds... The firm projects global ETP assets to increase to between .1 trillion and .7 trillion from a little over .5 trillion today.
McKinsey predicts that the ETF industry has hit an inflection point where product proliferation, specialization, price competition and additional actively managed funds will shift the ETF universe away traditional low-beta ETFs.
But the signs are becoming more evident that perhaps the ‘dumbing-down’ of investing is going a little bit too far. Every year, dozens of ETFs close down and, in 2011, those casualties included amongst their number the Faithshares Catholic Values ETF, Methodist Values ETF, Baptist Values ETF and Lutheran Values ETF, all of which were listed in the ‘Religiously Respectful’ sector and screened stocks on ‘best practices’ according to the guidelines of the related denominations. The Faithshares Christian Values Fund lasted an extra month but that too was shuttered in July (I’m not certain whether Lloyd Blankfein doing ‘God’s work’ was enough to make Goldman Sachs stock eligible for inclusion in the various portfolios but the point is now moot).
This past month has seen another example of how simplification can be an extremely dangerous thing for the investing public.
Now, my background is decidedly NOT steeped in the mathematical precision of volatility, but I recently attended the Global Volatility Summit in New York, where a colleague of mine (who just happens to be one of the finest volatility traders in the world) was speaking on a panel which included some of the best and brightest minds in that particular part of the business. A topic to which the panel returned on numerous occasions was the recent popularity of an ETN that, according to Bloomberg, provided investors with:
...a cash payment at the scheduled maturity or early redemption based on 2X the performance of the underlying index, the S&P 500 VIX Short-Term Futures Index less the Investor Fee.
In essence, gamers investors could buy a simple instrument that would give them DOUBLE the performance of the underlying VIX index (and why buy something that offers 1x performance when you can buy something that offers 2x, right?). It can’t really get any simpler than that, and with headlines about the VIX hitting 5 year lows abounding, plenty of people were applying simplistic logic and deciding that anything at a 5-year low could only really go up (personally, instead of such logic, I prefer fact - such as the fact that something can fall 5% a day, every day forever and NEVER reach zero, but.....) and, as a consequence, money flooded into the ETN as can be seen in the lower panel of the chart below.
But, as is usually the case, there was a slight problem and that slight problem came in the fact that this particular exercise on ‘dumbing-down’ had perhaps bitten off more than it could chew and any investor who had bought the ETF to try to make 2x the increase of something that was trading at a 5-year low had perhaps neglected one tiny thing - volatility is complicated stuff. Don’t believe me? Let’s ask the CBoE:
VIX is the square root of the annualized forward price of the 30-day variance of the S&P 500 return. This forward price is based on the replication of total variance by a portfolio of options delta-hedged with stock index futures. The construction of the replicating portfolio and the determination of its forward price from listed S&P 500 option prices is described below in greater detail.
Replication of Total Variance
The construction of the portfolio which replicates total variance is based on two observations:
(1) The total variance of the instanta-neous rate of return of the S&P 500 over a period T is equal to:
(2) A Taylor expansion of the logarithmic term ln(FT/F0) shows that it can be replicated by trading stock index futures and a continuum of out-of-the-money options:
I could go on (the CBoE do HERE if you’re interested) but I believe my point is made; how many of the buyers of the 2x VIX ETN had ANY clue what they were actually buying and how it would work? i would happily buy an ETF that provided me with 2x the inverse of that percentage.
Allow me to recount an anecdote from the aforementioned Global Volatility Summit in order to set up the next part of our discussion.
My colleague on the panel in NY made a point of describing, in what I shall simply call extremely plain language, what he thought of this particular product and expressed his opinion that it would end very badly for investors. I think it is fair to say that he took great pains to labour the point.
Ten minutes after the panel ended, he and I were chatting to a group of investors when a rather irate man appeared at his side and introduced himself as one of the architects of the ETN about which my colleague had been so disparaging. He had clearly sworn to defend his progeny against enemies both foreign and bombastic and he proceeded to do so with great vigour.
The conversation was fairly short and the man left in a short-paced and, from the back at least, unsatisfied stride for pastures less skeptical.
Sadly, he didn’t leave a card.
Two weeks after this conversation, the following story appeared on my Bloomberg terminal:
(Bloomberg): The plunge of an exchange-traded note backed by Credit Suisse Group AG highlights the growing risks for investors in some of Wall Street’s most complex exchange-traded products.
The VelocityShares Daily 2x VIX Short-Term ETN, which seeks to provide twice the daily return of the VIX volatility index, fell 30% on March 23 after Credit Suisse said it would begin issuing new shares. The Zurich-based bank stopped creating shares a month ago, unhinging the fund’s price from the index and leading to a premium over the indicative value that peaked at 89% on March 21 before plunging to about 7% two days later.
The story behind the plunge in the ETN is a cautionary tale that bears highlighting and a recent Bloomberg article on the subject illustrates perfectly how dangerous the dumbing-down of investing can be:
(Bloomberg): Michael Gamble, a 67-year-old retiree, doubled down on a volatility exchange-traded note backed by Credit Suisse Group AG last week as it declined to a record low price.
“When it started to fall, I bought more because I couldn’t believe how low it was going,” he said in a telephone interview.
“I didn’t realize I was playing with a hand grenade.”
Gamble, who lives in Frisco, Texas, didn’t know the product was trading at a premium to its targeted value, a rare event for ETNs, or that institutional investors were selling the notes short on a bet they would fall. The note tumbled by more than 50% on March 22 and March 23, costing Gamble about ,000.
The problem had been caused by the enormous inflows into the ETN which meant Credit Suisse could not issue more Notes:
(Bloomberg): Credit Suisse stopped issuing new notes on Feb. 21 after the market value more than quadrupled from the end of 2011, unhinging the share price from the index it tracked, the S&P 500 VIX Short-Term Futures Index. The price quickly developed a premium over the notes’ targeted value that peaked at 89% on March 21.
Hours before the bank said it would resume issuing new shares, the ETN’s price began falling on March 22 even as the index was rising. By the end of March 23, the premium had collapsed to 6.9% as the notes tumbled.
Ordinarily speaking, nobody who REALLY understood what they were doing would buy something that was trading at an 89% premium to the underlying index it was tracking, but there was enough ‘dumb money’ pouring into this ETF to drive it to completely the wrong price, ensuring a lot of money was lost when sanity returned. That money flowed in because an instrument was made available which made investing in something extremely complicated extremely simple. Convenience investing:
(Bloomberg): The iPath S&P 500 VIX Short-Term Futures ETN was among the 10 fastest growing exchange-traded products in the world in the first two months of 2012, gathering .1 billion in new assets...
For investors in the Credit Suisse ETN who didn’t pay enough attention, the freedom to access a complex market backfired after the Zurich bank ran into size limits on the derivative positions it took to ensure it could match TVIX’s targeted return.
Issuers typically stop adding shares when they reach a limit on their derivative positions that is either imposed internally or by an exchange or regulator...
But the fall of the TVIX wasn’t the first such collapse. An ETN which tracked natural gas prices had similar problems:
...The price of the iPath Dow Jones-UBS Natural Gas Total Return Sub-Index ETN, a note issued by London-based Barclays Plc, followed a similar trajectory over the past eight weeks, rising to a premium as high as 134 percent over its indicative value before falling to a premium of 56 percent over six trading days.
ETFs definitely provide easy diversification, tax efficiency and low expenses to investors while offering the benefits of ordinary shares such as limit orders, short-selling and options markets BUT, the desire to entice investors into the market by making a cornucopia of investment opportunities to them through simple vehicles has led to a ‘dumbing-down’ of the investment process in a never-ending quest for the simplest possible route into an idea when the plain truth is, there ARE no substitutes for doing the necessary research required when thinking about investing money into something. The unevenness of the regulatory regime surrounding these instruments has not exactly helped matters in that it has made investors believe that if they are allowed to do something, it must be safe.
The pejorative term ‘Videogame Generation’ is frequently aimed at the youth of the 90s and 00s who, it is alleged, sit in front of their TV screens mindlessly pushing buttons and paying no attention to the world around them. It is synonymous with a group of people who, it is felt, look for simplicity and convenience and cannot be bothered to engage with the world. It implies a certain amount of intellectual desertion on their part which, when one looks at the complexity of the games they are playing, is perhaps not justified.
If you have ever watched a rapt teen playing Guitar Hero or trying to infiltrate an enemy lair in Call of Duty, you will know, as i do, that these are extremely complex, hard to master and provide enormous gratification to those successful in winning.
It used to be the same with investing, but now that too has been dumbed-down - a dangerous direction in which to go.
2011 will long be remembered as the year in which a political union comprising some 27 different countries (17 of which formed a union within the union) reached the point of evaporation. It will be remembered for Central Bankers around the world trying desperately to keep the financial system from imploding through the application of never-before tried ideas on a massive scale and it will be remembered for generational moves in bond markets and precious metals. For twelve months analysts pored over data in an attempt to make sense out of a situation so complex as to literally leave the finest financial minds of their era baffled and at complete odds with one another.
Fortunately, amidst all this confusion, there was a way to cut through the fog and invest in a simple, convenient fashion through the use of two ETPs; Risk On (ONN) and Risk Off (OFF).
It doesn’t get any easier than that.
(Positions in any individual stocks discussed: NONE)
