If you work in an office that has financial news on in the background at all times, you might have noticed how volatile the markets have been lately. If you only hardly pay attention, and have no money at stake, it’s almost funny.Monday: markets are up. Tuesday: markets go down as yesterday’s winners short the market. Wednesday: markets open up again as investors cover their shorts. On Monday, they’ll interview a bullish investor who insists that the economy is showing clear signs of recovery. On Tuesday they’ll interview a bearish investor who is shorting the market.So on and so forth.
Occupy Wall Street protesters might be right down the street from the New York Stock Exchange, but the stock markets and their actual effects on day-to-day life couldn’t seem further apart.
I don’t have enough money to make money off of short-term trading gains, and short-term trading gains don’t do a thing for anyone but the traders and their firms. No value is added to the economy; rather, rent is extracted from it.
If only that fit on the back of a pizza box.
Wall Street and Chess Masters
Two stories that came out recently, both on Andrew Ross Sorkin’s DealBook, and both point to this precise problem that Wall Street has — that it seems completely disconnected with reality — albeit in different ways.
The first story is about how hedge funds value employees who are good at chess. You’d be shocked to learn how many hedge fund managers are masters and grandmasters at the game. There was even a program at Bankers Trust to hire master chess players and put them at a trading desk, regardless of their experience.
Not every person quoted in the story believes that chess and trading acumen correlate, but it does provide a window into just how these guys would like to be seen: erudite, thoughtful, cold and calculating geniuses.
ETFs: A Dangerous Game
The other story, which explains why markets have been so volatile, is troubling. In an interview with Doug Kass, manager of a hedge fund called Seabreeze Partners, Sorkin discovers that many people who understand the markets blame leveraged exchange-traded funds for the recent rise in market volatility, and maybe even the Flash Crash of 2010. Sorkin describes ETFs as “the new derivative,” for how much volatility and leveraged risk they have introduced to the markets.
ETFs are funds that provide a means for investors to bet short or long on a given basket of stocks, commodities, or indices. There is an ETF that tracks the S&P 500, for example. Another might track heavy metal futures. They’re sort of like mutual funds, but cheaper and quicker; investors can cash out at any point during the trading day, once they’ve hit their target.
Many ETFs are leveraged, using borrowed capital to increase their market exposure. If the fund has a 2:1 leverage ratio, investors’ earnings or losses are doubled, depending on where the market moves. This is what makes them attractive to investors — they can multiply the gains from their positions on the market with less capital than they would need with other investments. Sorkin reports that there are currently $1 trillion invested in ETFs.
Where leveraged ETFs introduce volatility is at the end of the day, when they “rebalance” themselves. Because leveraged ETFs must maintain a constant leverage ratio, they have to either buy more of their underlying assets at the end of a market gain, or sell off assets at the end of a bad day. This leads to wild market fluctuations about one hour before the bell, Sorkin points out. Because the investments are leveraged two or three times, the rebalancing is that much more severe — modest gains lead to double or triple the reinvestments, and modest losses, two or three times the sell-offs.
How in the world is that anything like chess? That’s more like playing Chutes and Ladders in an insane asylum.
Chess has set rules, and they’ve been the same for about 500 years. You cannot invent new instruments to track the end results of a Latvian Gambit, and then just knock over your opponent’s pieces once you want to cash out. You cannot bet against your own moves, lose the game, but win anyway.That the people running our economy see it as game-like at all is a bit disturbing. After all, who are the pawns on their chessboard?