October 23, 2013

Risk-Free Return

Everybody is talking about the weather. Why doesn’t somebody do something?

This witticism on human futility is often attributed to Mark Twain but traces to Twain’s friend and collaborator Charles Dudley Warner. A century later, it’s still funny.

There’s a lot of hand-wringing going on about interest rates, which from the IR chair may seem irrelevant until you consider that your equity cost of capital cannot be calculated without knowing the risk-free rate.

That and a piece in Institutional Investor Magazine some weeks back brought to my view by alert reader Pam Murphy got me thinking about how investors are behaving – which hits closer to investor-relations than anything.

When I say hands are wrung about rates, I mean will they go up? We’ve not had normalized costs of capital since…hm, good question. Go to treasurydirect.gov and check rates for I-Bonds, the federal-government savings coupon. I-Bonds pay a combination of a fixed rate plus an inflation adjustment. Guess what the fixed rate is? 0.00%. The inflation-adjusted return May-Oct 2013 is 1.18%.EE-Bonds with no inflation adjustment yield 0.20% annually. This is a 20-year maturity instrument. Prior to 1995, these bonds averaged ten-year maturities and never paid less than 4% annually, often over 7%. If the I-Bond pegs inflation at 1.18% every six months, translating to 2.36% annually, is the risk-free rate of return a -2.16%?

Which brings us back to investors. Your active holders compete against benchmarks and algorithms to deliver returns in excess of risk – alpha – by investing in your shares. The risk-free rate of return is nil, which on one hand means money is cheap but on the other that anybody wanting a return at all has got to take risk. It used to be that saving money guaranteed you a return. How yesterday, that notion.

Speaking of the past, delivering a conventional return of say 10% for taking risk, used to mean beating the risk-free rate by 43%, supposing that were 7%. That’s no small feat, but the equity market has routinely delivered those returns.

If the risk-free rate now on its face is about 20 basis points (and really a negative return, meaning if you take absolutely no risk at all, your dollars will shrink faster than 2% per year), what risk are you bearing to deliver 10%? Mathematically, 4,900% more. That’s obscene of course, but it’s telling you how markets are up 20% this year. Everybody, including all that money that should not be taking risks, is.

It also explains why investors have a hard time committing capital for long. Who can risk tying up money for years at such obscene risk levels? It affects the quality and duration of investment relationships.

Now add in market structure, which based on our data offers between 36-40% potential monthly returns to those committing capital for fractions of seconds in high-frequency trading models. How? That’s the spread in the average stock between high and low prices intraday every month. Played right in an arbitrage model, which means risking almost nothing, that’s the theoretical return.

Warren Buffett says to forget these distortions and focus on the long-term. Berkshire-Hathaway Class A shares have about 5% turnover annually, implying an average holding period in excess of 20 years, so his investors have done that. Of course, there’s no statistical arbitrage and no algorithmic trading in them. And the Buffett model is an acquisition model, the only protection against the horrors of currency depreciation and warped risk-free rates of return.

The problem with that model of course is that over time trading would cease and there would be no more companies to invest in. It would inevitably kill the goose that laid the golden egg.

What’s the lesson for IR? It’s a perspective that your executives would do well to grasp. This ain’t the weather. We can do something about it.

Share this article:
Facebook
Twitter
LinkedIn

More posts

dreamstime m 105330423
June 19, 2024

One of our customers at EDGE calculated that 82% of Demand in the S&P 500 is from three stocks (NVDA – now the largest –...

June 12, 2024

High-frequency traders are data-dependent. The Federal Reserve ought not be.  I’ll explain. The U.S. central bank today concludes its open-market (FOMC) meeting. Jay Powell speaks. ...

dreamstime m 4536788
June 5, 2024

Somebody pulled a pin and dropped a grenade in the stock market and nobody noticed. Let me explain: Now, there were explanations. Index options on...

dreamstime m 36265338
May 29, 2024

Size matters.  Does trade-size matter?  The average trade in S&P 500 stocks is 87 shares this week (five-day average). Think about that. Quotes are in...

dreamstime m 87656041
May 22, 2024

It’s tough being a market strategist.  Mike Wilson, chief equity strategist for Morgan Stanley, has thrown his bear towel on the laundry pile and lifted...

dreamstime m 17907458
May 8, 2024

Should a stock like COKE rise 20% in a day?  Executives love it, sure. But it’s aberrant behavior at loggerheads with what the dominant money...