A bad idea from Finra

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Good morning. The fine Binance is paying for violating money laundering laws ($4.3bn) is bigger than all profits ever made by Coinbase as a public company ($3.9bn). What that tells you about the state of the cryptocurrency industry we’re not sure, but it probably tells you something. We’re off for Thanksgiving, back on Monday. But feel free to email us anytime: robert.armstrong@ft.com and ethan.wu@ft.com.

Past performance, future results, and all that 

So here’s a bad idea. Finra wants to allow brokers to include projections of future performance in investment marketing materials aimed at the rich. From the Financial Times, a few days ago:

Brokers would be able to market some investments with projections of future performance and promise targeted returns when they are working with institutional and wealthy individuals, under a rule proposed by an industry self-regulatory body . . .

In the proposal, Finra said the change would pertain to brokers’ sales to institutions and investors with more than $5mn in assets. “A member’s views regarding the projected performance of an investment strategy or single security may be useful,” the authority said . . . 

Brokers would be required to have a reasonable basis for their estimates and to make sure that investors “have access to resources to independently analyse this information” . . . 

This is a bad idea not because it could lead rich people to lose some money. When rich people lose some money, that is good. The finance system works well when investors are protected from excessive confidence and credulousness by regular but non-catastrophic losses, whether at the hands of incompetent practitioners or market cycles. This prevents bubbles from inflating and subsequently popping. It’s better that these normal losses fall, to the degree possible, on “qualified investors” in Miami, rather than on retired schoolteachers in Duluth. So it probably makes some sense to have a special class of rich investors for the purposes of promoting and selling certain risky investment strategies. 

No, it is a bad idea because the projections of future performance will not be true, and saying things that are not true is best avoided.

It is a basic feature of finance that returns move in long regimes. A strategy that is well designed for and outperforms in one regime will underperform in another. Shifts between regimes are probably impossible to identify while they are happening, to say nothing of predicting them. So it is exactly when a strategy has established an excellent long-term record, one that screams out to be projected, that you really do not want to go around projecting it into the future. This is why the uber-strategy of all finance is diversification and rebalancing: you want multiple sources of return, because even the best sources dry up periodically. 

Here’s an illustration. Below is a chart of the relative value of the Russell 2000 value and growth indices. If you were in a growth-tilted fund from 2000 to 2006, you had some reason to think your manager had discovered a consistent source of excess return, and you may not have even known that the source of that return was the value bias. But then the world moved beneath your feet:

The point can be made in a slightly different way. The real return from US equities has very dependably reverted to an average of about 6 and three- quarters per cent over the long run. But “long run” is the crucial phrase here. Even a hugely reliable source of long-term returns can leave an investor nursing poor performance — for decades. The next chart shows, for a given month, the real annualised return of the S&P 500 over the next 20 years:

It is natural, looking at average performance, to think that over your investing lifetime, US equities will deliver 6-plus per cent real returns. But even if you are lucky enough to have a long investing lifetime, your returns could depart from that, by a lot. Taking average returns and projecting them forward is dangerous. 

Here is what the Finra proposal says about how such projections might be useful:

Projected performance may be useful for institutional investors and QPs that either have the financial expertise to evaluate investments and to understand the assumptions and limitations associated with such projections, or that have resources that provide them with access to financial professionals who possess this expertise. Such investors often test their own opinions against performance projections they receive from other sources 

What an intelligent investor asks, when presented with historical returns, is whether there is good reason to believe that those returns come from a sustainable source, or are instead just luck. Anyone who has skill to answer that question doesn’t need help from a broker’s projections.

Zombies aren’t real, part II

We wrote yesterday about fears of a corporate zombie apocalypse — the idea that legions of half-dead companies kept alive by easy money will soon die off en masse, killed off by higher rates, and cause systemic problems. We took a sceptical view: there are not all that many US companies that fit a strict definition of a zombie, and it is not clear that the number is growing all that fast.

There is, we should have noted, a tremendous amount of debate about this. The Bank for International Settlements has long warned that zombies were one productivity-sapping effect of lower-for-longer monetary policy. One IMF working paper published this June found, strikingly, that the share of global listed companies classified as zombies rose 4 percentage points to 10 per cent between 2008 and 2021. That paper’s definition of a “zombie” is broad: a non-financial company that for two consecutive years has an interest coverage ratio (ebit/interest expense) below 1, a leverage ratio (total debt/total assets) above the industry median, and negative real sales growth. No doubt, a group that meets all three criteria is wheezing.

But a glance at the paper’s appendix shows that the US is a rather different story than the rest of the developed world. During the period that global zombies were on the rise, the US zombie population was stable (in the chart below, the y-axis is zombie share of companies; blue line is listed companies; red line is privates):

US companies may just be a different. In an email, the economist Andrew Smithers pointed us to a 2022 paper from three Fed researchers, which used data from bank stress tests to conclude:

Despite the importance of the zombie phenomenon in Japan and Europe . . . zombie firms are not a prominent feature of the US economy; US banks reduce their exposure to firms that transition into zombie status or continue financing such firms at very restrictive terms; and zombie firms have a higher propensity of exiting the market through a reorganisation and liquidation procedure than other financially-impaired firms.

The zombie narrative, in its most frightening form, requires brain-eating. That is, it needs to be shown that investment is being consumed by bad businesses, depriving productive companies of capital. In the US, Smithers argues this is hard to square with widening profit margins, a falling cost of capital and stable-to-rising business investment. He also draws a distinction between companies that go bust when they can’t pay interest, and businesses that march on as long as output is greater than the cost of labour and maintenance. As Smithers put it, “a business only becomes unviable when the profits, after production costs of labour and bought in goods and services, have a lower value than its land, net trade credit and the scrap value of its equipment — none of which are affected by the businesses’ own interest costs”. 

This makes sense to us. Readers who are more fearful of American zombies than us are invited to write in with tales of the corporate walking dead. (Wu & Armstrong)

One good read

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