Pyramid Leverage

It is commonly accepted that “true” economic growth is the growth driven by technological innovation, and it is roughly approximated by a country’s GDP per capita growth. However, as I argued in an earlier post, short-term economic growth numbers could be distorted by monetary and fiscal policy choices. For example, a government may boost short-term GDP numbers by borrowing money through the sale of its long-term debt (say, twenty year bonds). By doing so, it employs the fundamental “time machine” feature of finance, which allows for the exchange of an uncertain future payoff for a certain payoff today. Ultimately, the repayment of the long-term government debt would be driven by the overall economy twenty years from now, i.e. people working, producing, consuming, and paying taxes then. Some of these people may not even be born today – how can we know for sure the number of workers and how productive they will be twenty years from now?

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Smart Beta as the “Easy” Button

Smart beta – another hot term these days… It has a nice familiar ring to it, as it sounds like an incremental improvement over the good old CAPM beta! There is something harmless and comforting in the name “smart beta”, especially after the past horrors of exotic derivatives and credit default swaps.

The brilliance of the marketing behind smart beta is akin to the “easy” button at Staples – it makes you think that there is a magic shortcut to solving the challenges of modern investing, almost as simple as pressing the easy button."easy" button at StaplesUnfortunately, the realities behind the easy button and smart beta investing are not simple at all. Instead of the easy button at Staples there are mind numbing choices of stationery and office products. Similarly, smart beta stands for hundreds, if not thousands, of funds that provide exposure to a multitude of risk factors, either in pure form or bundled with other risk exposures.

The true beauty of smart beta is in its very complexity, as it offers an opportunity for the extremely granular approach of fine-tuning your investment strategies across a multitude of risk dimensions based on your individual objectives. Navigating the smart beta world requires an understanding of all of the options, and it is ultimately your responsibility to pick the exact smart beta products that work specifically for you. And that isn’t easy at all, smart beta or not!


On Core and Satellite Approach to Hedge Fund Investing

A typical core and satellite portfolio approach involves investing in a “core” passively managed portfolio, and a “satellite” actively managed portfolio. The “core” is typically an index-tracking portfolio whose returns are driven by exposure to specific risk factors. Unfortunately, broad hedge fund index clones, that are currently being sold as “core” risk exposures are not exactly that. As I argued in my previous post, these clones attempt to replicate a mix of “cloneable” and “non-cloneable” funds, i.e. they are in fact “core” and “satellite” portfolios rolled into one product, with no transparency on the exact mix.

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Finance and the Purpose in Life

It is no secret that Main Street suspects that Wall Street high finance provides little meaningful contribution to society. Recent history suggests to a non-financial person that finance may in fact be taking rather than contributing. This opinion is expressed everywhere from Oliver Stone’s original “Wall Street” to the more recent Greg Smith’s “Why I am Leaving Goldman Sachs”. Even people in the finance industry have this nagging feeling about the purpose of life, as Matt Levine pointed out in his comment on Greg Smith’s article:

Smith is hardly the first banker to worry about whether his work makes the world a better place. Working at an investment bank involves trading off those negatives – stress, hours and a nagging sense of unfulfilled purpose – against the positive aspects of the job, which can be loosely summarized as “huge paychecks.”

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True Economic Growth vs. a Pyramid Scheme

Once you start thinking about economic growth, it’s hard to think about anything else.

– Robert E. Lucas

Q: What is the difference between maintaining sound fiscal policy and running a pyramid scheme with respect to government debt?

A: It all depends on the economy’s predicted growth rate.

What is economic growth, where does it come from, and how do we measure it? These are simple questions, but it is fundamentally important to get them right in order to understand what is ahead for the U.S. economy, and how its growth relates to government fiscal policy. Here I would like to take a look at how we measure economic growth, and argue that sometimes true economic growth may not be what it seems, at least in the short term.

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