Author Topic: Do we actually need complex investment vehicles?  (Read 1013 times)

Greystache

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Do we actually need complex investment vehicles?
« on: February 06, 2021, 08:06:18 AM »
I understand the usefulness of stocks and bonds for providing capital for businesses. Is there any real need or utility for complex investments like derivatives, credit default swaps, commodities futures, etc. Is there a reason why we need to be able to short a stock? Do these things serve a purpose or are they just ways to facilitate gambling and speculation? Would we be better off without them?

Malcat

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Re: Do we actually need complex investment vehicles?
« Reply #1 on: February 06, 2021, 08:53:42 AM »
Well, considering the vast majority of us here and at Bogleheads don't use them, then yeah, I would say that they aren't at all necessary.

Do they serve a purpose? Yes. Do some people make money using them? Yes. Does this mean we all should? No.

ender

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Re: Do we actually need complex investment vehicles?
« Reply #2 on: February 06, 2021, 09:05:12 AM »
I understand the usefulness of stocks and bonds for providing capital for businesses. Is there any real need or utility for complex investments like derivatives, credit default swaps, commodities futures, etc. Is there a reason why we need to be able to short a stock? Do these things serve a purpose or are they just ways to facilitate gambling and speculation? Would we be better off without them?

Who is "we" here?


MustacheAndaHalf

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Re: Do we actually need complex investment vehicles?
« Reply #3 on: February 06, 2021, 10:36:15 AM »
Vanguard mutual funds we invest in use derivatives.  For the S&P 500 index fund, they keep cash on hand for redemptions, and then achieve 100% exposure with derivatives.

Have you watched "The Big Short"?  The characters discover the insanity that leads up to the 2008 financial crisis, which makes for a compelling story.

I'd estimate I use derivatives more than almost all of our forum members, which wasn't true before the pandemic.  I responded in stages, eventually buying call options and leveraged ETFs.  I hope to go from mostly risky derivatives to mostly index funds as the pandemic ends.

maizefolk

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Re: Do we actually need complex investment vehicles?
« Reply #4 on: February 06, 2021, 11:00:13 AM »
I understand the usefulness of stocks and bonds for providing capital for businesses. Is there any real need or utility for complex investments like derivatives, credit default swaps, commodities futures, etc. Is there a reason why we need to be able to short a stock? Do these things serve a purpose or are they just ways to facilitate gambling and speculation? Would we be better off without them?

I would say commodities futures serve an important purpose by letting businesses protect themselves from big price swings. In those cases the bad price swings are almost always worse news than the good price swings are good news. Airlines buy commodity futures to hedge against big increases in the price of fuel which they hadn't taken into account when they priced the tickets for their flights. Farmers sell commodity futures to make sure they'll at least be able to cover their variable input costs even if the price of corn or soy crashes between the time they plant and the time they harvest. If the only option were selling on the spot market, even more farmers would go bankrupt in the bad years than already do.

Michael in ABQ

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Re: Do we actually need complex investment vehicles?
« Reply #5 on: February 06, 2021, 11:56:52 AM »
I understand the usefulness of stocks and bonds for providing capital for businesses. Is there any real need or utility for complex investments like derivatives, credit default swaps, commodities futures, etc. Is there a reason why we need to be able to short a stock? Do these things serve a purpose or are they just ways to facilitate gambling and speculation? Would we be better off without them?

They serve a real useful purpose in the economy. However, they can also be used for straight up gambling.

Airlines have huge expenses for jet fuel so they spend a few dollars per barrel to make sure they can lock in the price for 6-12 month out as if oil remains at $50/bbl thus giving them some consistency for planning. If oil prices suddenly shoot up to $100/bbl they may not have cash on hand to cover that huge increase. For a business to keep massive cash reserves is a sign that they're not efficiently putting that money to work (marketing, upgrade equipment. hire additional labor, general expansion, etc.) and will negatively impact their stock price.

If Boeing is about to sell $2 billion in Jets to Turkey, they don't want to lose $100 million when the exchange rate on USD to Turkish Lira changes. So they may purchase some foreign currency as a a hedge.

Credit default swaps are a fancy way of saying insurance for bond funds. So they provide downside protection for something like a pension fund who may buy $100 million of a single bond issue.

ctuser1

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Re: Do we actually need complex investment vehicles?
« Reply #6 on: February 07, 2021, 07:31:10 AM »
In an ideal world, all derivatives will be used just for hedging (e.g. the jet fuel example above), and all banks will only do pass-through trading mostly to facilitate hedging, and will take no positions in the market where they can lose money.

The above is absolutely critical for the functioning of the economy. Without it, Vanguard will lose too much money in "tracking error" and their ETF's would no longer be as close a proxy for SP500 as they are right now, airline tickets will be more expensive (airlines aren't experts in commodities and inflation hedging, so it will cost them more to do it than to use derivatives to pass it on to more sophisticated investors) etc. etc. etc. It will even impact much more obscure things like Fed's ability to infuse liquidity into the markets and hence the entire economy (I know because I am a code monkey currently working with a set of products - quite complicated derivatives - that are fed mandated and without them it will be very expensive for any bank - and hence it's clients - to manage it's counterparty risk and hence liquidity).

In reality, however, it is practically impossible to distinguish these legitimate hedging activities with a rogue trader taking prop positions aimed at juicing up his portfolio performance (and hence his bonus). It is very possible to take prop position by a trick known as "over-hedging". This is precisely what a JPMorgan trader did a few years ago, causing a $2B loss. And you only hear about the losses because they make news. I bet there are many other instances of this going on somewhere.

So, in the end, it is always a cat and mouse game between the regulators and the traders at banking institutions. 

celerystalks

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Re: Do we actually need complex investment vehicles?
« Reply #7 on: February 07, 2021, 08:01:36 AM »
I understand the usefulness of stocks and bonds for providing capital for businesses. Is there any real need or utility for complex investments like derivatives, credit default swaps, commodities futures, etc. Is there a reason why we need to be able to short a stock? Do these things serve a purpose or are they just ways to facilitate gambling and speculation? Would we be better off without them?

I would say commodities futures serve an important purpose by letting businesses protect themselves from big price swings. In those cases the bad price swings are almost always worse news than the good price swings are good news. Airlines buy commodity futures to hedge against big increases in the price of fuel which they hadn't taken into account when they priced the tickets for their flights. Farmers sell commodity futures to make sure they'll at least be able to cover their variable input costs even if the price of corn or soy crashes between the time they plant and the time they harvest. If the only option were selling on the spot market, even more farmers would go bankrupt in the bad years than already do.

Agreed. Futures allow commodity producers and users to sell their short term volatility risk to the financial markets by locking in prices.

Also, successful future buyers presumably have sophisticated research outfits which anticipate supply and demand during the contract period and then price accordingly. This future price signal will influence the behavior of producers and consumers today and generally has a leveling effect on the supply and demand of the underlying commodity thereby dampening boom and bust cycles.


vand

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Re: Do we actually need complex investment vehicles?
« Reply #8 on: February 07, 2021, 08:09:00 AM »
A lot of company directors are essentially paid in share options. The argument is that it aligns management goals with shareholder goals.. at least in the short term.

Malcat

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Re: Do we actually need complex investment vehicles?
« Reply #9 on: February 07, 2021, 08:10:29 AM »
Sorry, is the question whether we as individual investors need these investment vehicles or whether or not they should exist at all??

Who is "we" and what constitutes "need" in this question??

waltworks

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Re: Do we actually need complex investment vehicles?
« Reply #10 on: February 07, 2021, 08:15:04 AM »
My personal feeling is that all of them are fine, with the exception of shorting.

The market can signal it's poor view of a company without anyone shorting the stock, so I'm not convinced by the price discovery argument. If nobody is buying and everyone is trying to sell, that's plenty of price discovery already. Shorting has ended up, in some cases, being a way to *attack* a company for profit (ie Tesla).

I think basically everything else is fine, but if I ran the SEC, I'd ban shorting.

-W

celerystalks

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Re: Do we actually need complex investment vehicles?
« Reply #11 on: February 07, 2021, 08:20:15 AM »
My personal feeling is that all of them are fine, with the exception of shorting.

The market can signal it's poor view of a company without anyone shorting the stock, so I'm not convinced by the price discovery argument. If nobody is buying and everyone is trying to sell, that's plenty of price discovery already. Shorting has ended up, in some cases, being a way to *attack* a company for profit (ie Tesla).

I think basically everything else is fine, but if I ran the SEC, I'd ban shorting.

-W

If the company is sound and the shorts have driven the price too low then shareholders can buy up shares at a good discount or the company itself can buy back shares from the market. If neither of these two things happens, then maybe the company should weather some attacks.


maizefolk

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Re: Do we actually need complex investment vehicles?
« Reply #12 on: February 07, 2021, 08:27:15 AM »
My personal feeling is that all of them are fine, with the exception of shorting.

The market can signal it's poor view of a company without anyone shorting the stock, so I'm not convinced by the price discovery argument. If nobody is buying and everyone is trying to sell, that's plenty of price discovery already. Shorting has ended up, in some cases, being a way to *attack* a company for profit (ie Tesla).

I think basically everything else is fine, but if I ran the SEC, I'd ban shorting.

-W

I'm not convinced we as a society need short selling either, but to play Devil's advocate:

Short selling also provides the financial incentive for groups like Hindenburg Research, which were the ones who figured out Nikola (then a $20B company) had just rolled their truck down a hill to make a video that looked like it was driving under its own power and were claiming credit for building components in house that they'd actually bought from other companies and just covered up the labels with stickers.

https://arstechnica.com/cars/2020/09/nikola-admits-prototype-was-rolling-downhill-in-promotional-video/

In principle, people already invested in the company, or considering in the company, also have a financial incentive to scrutinize the public statements and reports of a company, but that incentive doesn't seem to work as well, perhaps because potential investors who discover problems that are a reason not to invest don't have any particular incentive to publicize their discoveries, and actually a modest disincentive to do so.

waltworks

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Re: Do we actually need complex investment vehicles?
« Reply #13 on: February 07, 2021, 09:03:58 AM »
I'm not convinced we as a society need short selling either, but to play Devil's advocate:

Short selling also provides the financial incentive for groups like Hindenburg Research, which were the ones who figured out Nikola (then a $20B company) had just rolled their truck down a hill to make a video that looked like it was driving under its own power and were claiming credit for building components in house that they'd actually bought from other companies and just covered up the labels with stickers.

https://arstechnica.com/cars/2020/09/nikola-admits-prototype-was-rolling-downhill-in-promotional-video/

In principle, people already invested in the company, or considering in the company, also have a financial incentive to scrutinize the public statements and reports of a company, but that incentive doesn't seem to work as well, perhaps because potential investors who discover problems that are a reason not to invest don't have any particular incentive to publicize their discoveries, and actually a modest disincentive to do so.

Yeah, that's a good point. My counter would be that the victims in this type of fraud are basically just rich retail/accredited investors, generally. Nobody figured out Enron or VW by because short sellers were sniffing around, either.

Further, I'm ok with some level of fraud if it means we get more genuine innovation from small companies without the threat of shorts snuffing them out.

I believe the SEC already has pretty big whistleblower bonus money available if you come forward with evidence that a company is defrauding investors, too.

I guess it depends on your point of view a bit. I'm ok, for example, with a lot of food stamp fraud in order to make really sure one actual hungry kid gets the food they need. Some people don't feel that way.

-W

maizefolk

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Re: Do we actually need complex investment vehicles?
« Reply #14 on: February 07, 2021, 10:16:49 AM »
I agree that accepting a bit more fraud to get more real innovation is a favorable trade off in our society. In aggregate we have plenty of money and really need more innovation. But are innovative small companies currently operating under threat from being snuffed out by short sellers?

Aside from cases of complete and obvious fraud, I'm not familiar with cases of short selling actually driving a company out of business. However, I'll acknowledge up front that may simply reflect the limits of my reading on the topic.

PDXTabs

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Re: Do we actually need complex investment vehicles?
« Reply #15 on: February 07, 2021, 11:59:08 AM »
My personal feeling is that all of them are fine, with the exception of shorting.

Shorting arguably helps with price discovery and lowers the cost (in fees) of our ETFs. Why you might ask does it lower the fees in our ETFs? Because someone has to loan those shares, and it is often large institutions like Vanguard, and they make interest on the loans.
« Last Edit: February 07, 2021, 12:28:55 PM by PDXTabs »

MustacheAndaHalf

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Re: Do we actually need complex investment vehicles?
« Reply #16 on: February 07, 2021, 10:42:53 PM »
If shorting is banned, then loaning equities needs to be banned as well.  Loaning stock, followed by getting it back later, is shorting.  That means Vanguard's mutual funds would lose a source of revenue, and might have to raise expense ratios.  You'd see an impact in ordinary investors, not just rich ones.  Fidelity's zero fee total market fund might need to close, since that's a significant source of revenue.

I expect a ban on shorting would make markets more volatile.  That would ban arbitrage, which typically involves a long and short position.  I expect it would have a huge impact on high-frequency trading (HFT), forcing many of them to shut down.  One thing that gets lost about HFT firms: they add liquidity to the market.

SEC has awarded $676 million to whistleblowers since the program started in 2012 (2/3rds of it in the past 2 years).  How many claims got nothing?  Meanwhile the markets offer far larger rewards with far greater speed.
https://www.sec.gov/news/press-release/2020-266

If nobody can short a stock, can they buy PUT options that achieve the same thing?  When I create a "call option" contract, my account shows I'm short that contract.  Would PUT and CALL options be banned, when shorting is banned?

It's interesting not just because waltworks raised the question, but because Congress might be considering it.  I think there's a huge list of unintended consequences.

Paul der Krake

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Re: Do we actually need complex investment vehicles?
« Reply #17 on: February 07, 2021, 10:54:20 PM »
Short selling is as natural as buying long and helps not only price discovery, but also overall liquidity. The option of "not buying" is not enough, that's merely the neutral choice.

Elon Musk and other CEOs who routinely rail against short sellers would find another boogeyman.

Paul der Krake

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Re: Do we actually need complex investment vehicles?
« Reply #18 on: February 07, 2021, 10:57:05 PM »
SEC has awarded $676 million to whistleblowers since the program started in 2012 (2/3rds of it in the past 2 years).  How many claims got nothing?  Meanwhile the markets offer far larger rewards with far greater speed.
https://www.sec.gov/news/press-release/2020-266
The whistleblower program exposes wrongdoing. Short sellers don't need wrongdoing to make money shorting stocks.

MustacheAndaHalf

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Re: Do we actually need complex investment vehicles?
« Reply #19 on: February 08, 2021, 01:21:16 AM »
SEC has awarded $676 million to whistleblowers since the program started in 2012 (2/3rds of it in the past 2 years).  How many claims got nothing?  Meanwhile the markets offer far larger rewards with far greater speed.
https://www.sec.gov/news/press-release/2020-266
The whistleblower program exposes wrongdoing. Short sellers don't need wrongdoing to make money shorting stocks.
The money shorting stock for wrongdoing is larger than the SEC rewards.  I don't know how many short owing to wrongdoing versus other reasons - certainly that's not everyone.  I'm saying it's more significant than the SEC program.

Nikola short interest grew each quarter in 2020:
3/31 .. 6/30 .. 9/30 .. 12/31
0.8M .. 11.5M .. 36M .. 54M shares
$10.64/sh .. $67.53/sh .. $20.48/sh .. $15.98/sh
https://www.nasdaq.com/market-activity/stocks/nkla/short-interest

The SEC began investigating them very recently, long after short sellers did.  Like my example of Michael Burry's hedge fund, it's another example where the profits from short sellers off wrongdoing were greater than the entire SEC whistleblower program taken together.  If the SEC decides the whistleblower complaint helped them on their NKLA investigation, that reward will be much smaller and much later than those who shorted NKLA stock.  So I think the SEC's program is not a substitute for short selling.

Greystache

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Re: Do we actually need complex investment vehicles?
« Reply #20 on: February 08, 2021, 08:10:18 AM »
Thanks to everyone who responded with real world concrete examples of how these things are used.  I guess they are like any other tool. They can be used responsibly or they can be abused with dire consequences.

ctuser1

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Re: Do we actually need complex investment vehicles?
« Reply #21 on: February 08, 2021, 09:11:37 AM »
Market makers can't effectively function without shorting.

Without market makers (or "specialist's" in NYSE parlance), there is no liquidity. Lack of liquidity in a market that has to clear (else there are grave consequences) has real societal cost.

Mr Mark

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Re: Do we actually need complex investment vehicles?
« Reply #22 on: February 09, 2021, 12:01:23 PM »
I understand the usefulness of stocks and bonds for providing capital for businesses. Is there any real need or utility for complex investments like derivatives, credit default swaps, commodities futures, etc. Is there a reason why we need to be able to short a stock? Do these things serve a purpose or are they just ways to facilitate gambling and speculation? Would we be better off without them?

Yes, I think they serve a purpose.

We ride the long term benefits of owning the market, via Bogle/Vanguard. In the long term, the US stock market has a well proven history of gains I won't get into here.

But, the constant churn of trading, arbitrage and leverage establishes value via liquidity, pays for all the mechanisms of the market, pays for analysts etc, and provides grease to the wheels of commerce. If we were all 100% index, who would determine the 'value' of companies? Who would make sure the bad businesses get squeezed of capital, or even sold short? The futures and options market allows risk & uncertainty to be transferred from someone who doesn't want it (or can't afford to take it) to those who do or are in better shape to manage it.

In return, the day traders, hedge fund investors, HFTs, market makers, high fee 401k funds and idiots invested in Edward Jones et al provide the cash. We as index investors 'pay' via a buy/sell spread I guess, and slightly lower overall market returns?