Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:

A review of TAA performance

Reconciling tax cuts with debt growth

The different thinking patterns of bond and stock investors

Returns are decelerating in the farm belt

Passive has its risks

Risk management must consider fat tails

Autonomous vehicles and package delivery

A case against indexing bonds

Is global trade growing again?

Start investing early

Vulture investors want to become long-term investors.

Index funds are very popular

Scrutinizing an old market saw

Even the pros can get burned speculating

Keeping the weight off

There’s more to it than an algorithm

The challenge of value investing

# Month: April 2017

## Implied volatility and realized volatility

Volatility is an important consideration in the pricing of options. Holding constant the strike price and expiration of an option, future volatility assumes a paramount position in determining the value of an option.

We don’t know with certainty the future volatility of a stock, but we can use option pricing models like the Black-Scholes Model to derive an *implied *future volatility. If we know the values of all the other inputs into the Black-Scholes Model except for future volatility, we can use the model to *solve* for volatility. Thus, for a certain option contract if the price is X and we assume that the price of the option is neither overvalued nor undervalued, then the expected volatility of the stock must be Y if we accept the assumptions of the Black-Scholes Model.

A thoughtful investor will wonder if expected volatility has anything to do with actual volatility. In other words, if the option price implies a volatility of Y over the next year, a year from now what will the volatility have actually been?

This is an important question. If implied volatility is less than the actual volatility in the future, then the price of the option is too low in relation to the potential payoffs. On the other hand, if the implied volatility is greater than the actual volatility in the future, then the price of the option is too high.

As one might expect, there are times where either happens. Sometimes the actual volatility is greater (less) than the implied volatility, with potentially harmful (beneficial) effects for the person who owns the option.

However, on average, the evidence suggests that implied volatilities are too high on average over the long-term. This implies that options tend to be overvalued and that, on average, buying them may not be a profitable decision. Of course, the potential returns depend entirely on the specifics of the option contract and the performance of the underlying stock. Past performance is no guarantee of future performance.

## 529 Active Management

529 Plans are a popular tool for funding education expenses. The owner of the 529 account contributes money, which is invested in securities. Investment income and capital gains are not taxed while the funds remain in the account. Withdrawals are exempt from income tax if the money is spent on qualified educational expenses.

529 Plans are not designed for buying and selling. According to 26 U.S. Code § 529(b)(4),

A program shall not be treated as a qualified tuition program unless it provides that any contributor to, or designated beneficiary under, such program may, directly or indirectly, direct the investment of any contributions to the program (or any earnings thereon) no more than 2 times in any calendar year.

For the investor who would like to make more than a few changes in a year, 529(b)(4) would appear to be a significant barrier.

At least a few 529 plans offer a loophole, in that “roll-overs” allow “do-overs.” One is allowed to roll over 529 accounts:

- from one beneficiary to another, under certain circumstances; and
- from one state-sponsored plan to another.

We have not spoken with every state 529 plan, but for the ones we did talk to, each rollover allows a reset of the investment options that does not count towards the two-per-year limit on investment directions.

Thus, if one has multiple children, one could roll the 529 money from one child to another apparently without limit, changing the investment choices along the way. When it comes time to pay the qualified educational expenses of a particular child, one would roll the money into an account with that child as the named beneficiary and withdraw the money.

Implementing this strategy would be cumbersome. Each rollover requires submitting paperwork. In addition, one must accept the time lag between making the investment decision and the days it takes for the 529 administrator to process the rollover request.

*The author is not a tax professional, and thus does not offer tax advice. One should discuss this planning idea with a qualified professional before implementation.*

## What we are reading on 4/25/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:

The unevenness of skill development

Quants versus stock pickers

Autonomous vehicles are coming

And now … flying cars?

Can retailers master big data in order to survive?

Is angel investing worth it?

Cell phone use while driving is very popular

Cycling is good for health

Don’t let fear psych you out!

Bring on the dopamine!

Sorghum syrup.

The professors who became activist investors

Indoor farming is growing

Is the threat of climate change about to effect Florida real estate pricing?

The pension dominoes are starting to fall …

Will electric trucks be available sooner than expected?

Parents probably should not borrow money to send the kids to college

Hussman’s latest

## The cross-section of implied volatility

Stock option prices are in part a function of future volatility. Holding all other variables constant, the price of an option on a stock with higher future volatility is worth more than the price of an option on a stock with lower future volatility.

Of course, we don’t know in advance the future volatility of a stock. But using an option pricing model like the Black-Scholes Model, we can use the current price of a stock option to calculate an *implied volatility *for a stock. In essence, if the price of the stock option is X, then investors must be thinking that the volatility will be Y.

If options are available for a given stock, there are usually many from which to choose. One can select the combination of option expiration, strike price and option type that suits the investor’s preferences.

Different option contract terms usually result in different option prices. A model like the Black-Scholes Model accounts for many of the ways in which option contracts can vary. One can use the model to compute an implied volatility of the underlying stock. Select an option and plug the known variables into a Black-Scholes Model tool (stock price, option price, option strike price, expiration, interest rates and the type of option) and one can solve for the implied volatility.

Some people are surprised to learn that for the same underlying stock, the often indicates varying implied volatilities. Consider two call options that are the same in all respects except one has a different strike price than the other. The option with the higher strike price should be worth less than the option with the lower strike price. The Black-Scholes Model accounts for differences in strike prices.

In practice, we sometimes find that the out-of-the money options have higher implied volatilities. An out-of-the-money call option has a strike price higher than the current price of the stock. In other words, the option gives you the right to buy the stock at $50, but the stock is currently trading at $45. For this situation, the stock must move up quite a bit before the call option becomes worth anything at expiration. In contrast, an at-the-money option could have a lower implied volatility. For an at-the-money option, the stock price and the strike price are the same; as soon as the stock price moves up, the call option has value at expiration.

The cross-section of implied volatilities sometimes create a volatility smile:

A creative investor will see the differences in implied volatility and wonder about the profit opportunities. Of course, the potential returns depend entirely on the specifics of the option contract and the performance of the underlying stock. Past performance is no guarantee of future performance.

## What we are reading on 4/21/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:

Anti-corporatism seems popular

Wisdom from Howard Marks

Ted Williams and investing

The many errors in investing

Is EM shaping up?

The advantages of collaboration

Junk bond asset allocation

On the benefits of stress

What’s going on with the most successful people?

Pension plan restructurings

Wage stagnation

Investment quotations

Disintegrating Obamacare

Road testing autonomous vehicles

Fear is a great change agent

## The 529 Irrevocable Trust Strategy

The “529 Irrevocable Trust Strategy” uses an existing irrevocable trust to fund a 529 account. Under the right circumstances, the strategy can result in substantial income tax savings.

This strategy starts with an already-existing and funded irrevocable trust. An irrevocable trust is its own legal person. A grantor creates and funds the trust. It has its own taxpayer identification number and files its own income tax returns if it has income above a certain amount. A trustee operates the trust for the benefit of the beneficiaries of the trust.

Trust income is taxed at much higher rates than personal income. Compare the following 2016 tax tables:

Tax Bracket |
Trust |
Single Person |

10.0% | $0 – $9,275 | |

15.0% | $0 – $2,550 | $9,276 – $37,650 |

25.0% | $2,551 – $5,950 | $37,651 – $91,150 |

28.0% | $5,951 – $9,050 | $91,151 – $190,150 |

33.0% | $9,051 – $12,400 | $190,151 – $413,350 |

35.0% | $413,351 – $415,050 | |

39.6% | > $12,400 | > $415,050 |

A trust hits the top tax bracket at only $12,401 income. An individual would need $415,051 of income to be taxed at the same rate.

Getting money out of the trust is one way to reduce the painful trust income tax rate. However, perhaps there are good reasons to keep the money out of the beneficiaries’ control: for example, perhaps the idea is to have the trust as a protected source of money to fund the education expenses of the beneficiaries.

If funding education is an objective of the trust, the trustee could consider having the trust set up and fund a 529 account. Most people think of 529 accounts as something available only to a natural person. However, there appears to be no legal prohibition against doing so within a trust.

The author has set up this type of account using an irrevocable trust. The irrevocable trust owns the 529 account. The beneficiary of the 529 account is the same as the beneficiary of the irrevocable trust. The trust can contribute to the 529 account up to the annual gifting amount each year.

In implementing this plan, the author has reduced the income tax rate on the education funds within the trust from the punitive trust income tax rates to as little as zero if the funds in the 529 account are used for qualified educational expenses.

*The author is not a tax professional, and thus does not offer tax advice. One should discuss this planning idea with a qualified professional before implementation.*

## The bottom-up way to valuing a stock option

The challenge to figuring out the value of a stock option is guessing correctly what will happen to a stock’s price. Of course, it is impossible to know in advance what a stock will do. Faced with this problem, some option investors turn to the Black-Scholes Model to determine an option’s value. As we have seen, the Black-Scholes Model has its own challenges – specifically, what is the expected volatility of the stock and will the future returns be normally distributed.

Let’s outline a different approach, one that should be accessible to anyone with programming skills and a modest knowledge of statistics.

Instead of assuming a normal distribution of returns (as required by the Black-Scholes Model), why not compute the actual distribution of historical returns and adapt them to option prices? One can refine the analysis by partitioning the return history. For example, one could look at the forward return distribution during periods of high and low volatility.

If one has a set of historical returns that could serve as a better-than-average proxy for what might happen, one can create a distribution of returns. One simply sorts the returns and assigns them to percentile buckets. Ideally one wants a few dozen observations for each percentile in the distribution. This implies 10,000 or more observations. If one does not have enough data, one can try a Monte Carlo simulation to increase the sample size. At the end of the process one has 100 potential outcomes, each with its own average return.

Use the returns to calculate the future stock price for each of the 100 potential outcomes. Simple math will allow one to calculate the value of the option for each of the stock prices. From there, one multiplies each of the future option values by 1% and sums the result.

We did this on a stock and came up with the following return distributions:

“Scenario 1” is the Monte Carlo-derived distribution of returns, based on the historical returns of a specific stock. “Scenario 2” follows the same procedure as “Scenario 1” but uses returns only from periods that share the characteristics of the market at the time of the study. BSM stands for “Black-Scholes Model.” It’s a normal distribution that has been adjusted to have the same average and standard deviation of returns as Scenario 1.

Notice that the return distributions are not the same, particularly on the upside potential. When we use the distributions to calculate the expected value of an option, we come up with very different prices depending on which of the three distributions one uses. * If *one has confidence that the past distributions will repeat in the future (and that is a big “IF”), one might be able to identify some interesting arbitrage opportunities.

## What we are reading on 4/18/2017

Here’s what we are reading today. We do not necessarily agree with the opinions expressed therein and we disavow any actual or implied investment advice therein. In no particular order:

On the relationship between momentum and sentiment

Investment returns and active bond management

Do CEOs game the numbers in order to pad their compensation?

Do ETFs function effectively for emerging markets bonds?

Sleep is the new status symbol.

Hussman’s latest

Making the case against dividends

Can an ETF become too big?

## Base Money update April, 2017

Each month, we track the monetary base for the world’s major central banks. Changes in the monetary base *may* have an effect on the prices of financial assets such as stocks and bonds.

Notwithstanding a retrenchment in October and November (2016), the central banks we cover continue to create money at an astonishing rate. Here is the data through the end of the last month:

Here’s the month-by-month data:

Nov | -217,026 |

Dec, 2015 | 94,350 |

Jan | 41,483 |

Feb | 294,299 |

Mar | 333,907 |

Apr | 328,052 |

May | -220,649 |

Jun | 490,995 |

Jul | 50,963 |

Aug | 12,767 |

Sep | 246,331 |

Oct | -277,932 |

Nov | -297,030 |

Dec, 2016 | 79,549 |

Jan | 393,112 |

Feb | 138,723 |

Mar | 365,484 |