Larry Swedroe: Rising Rates Increase Worries

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marcopolo
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Re: Gems -- A look back to see what worked--and what didn't

Post by marcopolo » Sat Jan 11, 2020 8:21 pm

Taylor Larimore wrote:
Sat Jan 11, 2020 8:03 pm
Bogleheads:

As many Bogleheads know, I have read many books and have extracted valuable quotes from the best books to help Bogleheads succeed. I call these quotes "Gems."

We can look back at older books and see what worked and what didn't. This is one of my favorite books written in 2003 by Larry Swedroe: "The Successful Investor Today--14 Simple Truths You Must Know When You Invest."

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "Knowledge is power, but only up to a point. -- Investors must be extremely selective as to where and how they spend their time collecting information.
Whatever happened to that guy? He seemed to have a lot of good advice.
:beer
Once in a while you get shown the light, in the strangest of places if you look at it right.

larryswedroe
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Re: Larry Swedroe: Rising Rates Increase Worries

Post by larryswedroe » Sat Jan 11, 2020 8:33 pm

Northern
I’m more concerned with correlation to some of our fixed income assets.
First, if take from equity side maybe you give up slight expected return but you cut volatility by about 80%. Good trade. Second if take from bond side you get big premium and get rid of inflation risk in return for illiquidity and some, but not huge, economic cycle risk.

With the AQR fund you are paying to hedge out market risk. The ER is much higher than it would be to hold the long asset classes. That excess ER is equivalent to a higher negative carry for the hedging.
You are not hedging out market risk here. You are diversifying sources of risk across multisources each with premiums and uncorrelated to both stocks and bonds and each other.
As to SSRIX I was not suggesting cherry picking the business but the timing of when the reinsurer chooses to sell a full slice of their book of business. The reinsurer decides when to sell and they have detailed actuarial knowledge of the portfolio. They can sell full slices when it is suboptimal to raise cash to rebalance the risk with new business. Suppose they have a large liability on their actuarial balance sheet that they believe has become more risky. That is a great time to sell a slice of their full business to SSRIX.

Not thinking of this right. SR is a long term strategic partner with the reinsurers. They don't buy one year and not the next, and so on. Also the whole idea doesn't make sense because reinsurance contracts are typically annual, and risks don't change like with stocks. So the risk you are worried about isn't one.
Ceding back some of the premium in the contract also makes it a nonstarter for me— not transparent enough.
This is no different than reinsurance, so structured differently as they don't do quota share deals with insurers, they bid on offers. But the reinsurer will not get the full premium as part of the premium is not for risk but to cover the expenses of the insurer in origination etc. And while they cede back some of the premium they are not taking all the risks either, so without even considering the much lower costs they should cede back some. That's the problem, people make judgments like scandalous fees without even understanding the nature of the investment. And I've seen advisors make the same mistake, having incorrect beliefs that they are 100% sure sometimes they are right about, but they are not.

I'll close by saying certainly one should not invest in something on your own without fully understanding all the risks and benefits. One role of a financial advisor though is to do the due diligence and make sure they fully understand all the risks. In the case of SR we took about three years before we committed our own assets, and hired an industry expert as a consultant to help us make sure we fully understood everything (I have very significant personal assets invested) to make sure we fully understood all the issues.

At any rate I hope this was beneficial in at least providing some information about these alternatives and perhaps providing better perspectives. BTW, there is another well run fund XILSX which has somewhat lower ER of 2%. .

Best wishes
Larry

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by Northern Flicker » Sat Jan 11, 2020 9:51 pm

First, if take from equity side maybe you give up slight expected return but you cut volatility by about 80%. Good trade. Second if take from bond side you get big premium and get rid of inflation risk in return for illiquidity and some, but not huge, economic cycle risk.
You would need to know more about our portfolio before dismissing my concern of correlated risk between LENDX and some of our fixed income holdings, which are not a vanilla bond index fund.

Maybe if I found the time I could go through the 5,700 page annual report to try to make such an assessment, but the minuscule likelihood I would do so is quashed by the fact that the product appears only to be available through a RIA.
You are not hedging out market risk here. You are diversifying sources of risk across multisources each with premiums and uncorrelated to both stocks and bonds and each other.
I believe AQR hedges our market risk in their long-short style investments so that there is exposure to the style premium without being dominated by market beta.

With respect to SSRIX, if they cede some premium then any timing risk can in any case just be absorbed into valuation risk. Whenever they get a quota, they have to get it at a fair price. They are going toe-to-toe with big reinsurance companies with armies of actuaries. If SSRIX doesn’t have their own actuaries to price the liabilities, I am not fully confident I’d be getting a fair deal, and lack the visibility or expertise needed to do the determination myself. What are they spending the high ER on if it does not include an actuarial analysis of the value of what they are buying?

I will pass.
Index fund investor since 1987.

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by larryswedroe » Sun Jan 12, 2020 9:02 am

Northern
I believe AQR hedges our market risk in their long-short style investments so that there is exposure to the style premium without being dominated by market beta.
Misunderstanding what they do. There is no hedging whatsoever, and there are many positions which have nothing to do with the stock market.
Example, they go long value and short growth, so no net exposure to market, just value factor. They go long some commodities and short others based on carry and momentum factors, they go long some currencies and short others, so not market related at all. This is one of the problems, many people criticize funds without knowing what the fund actually does, they think they know, but what they know is often wrong.

I also did not dismiss concerns you have, just pointed out the pros and cons, the trade offs. And that would raise the question of whether the portfolio would be better with LENDX than some of existing holdings. What risks/premiums are the trade offs. And note the length at 5,700 pages is due to SEC requirement they list EVERY holding and they buy literally thousands of small business and consumer loans so every one must be listed. What should be shown is the required underwriting standards, not each loan. Does SEC think anyone actually looks at that stuff?

As to SRRIX, sorry I tried to explain why your concerns are not valid. It has to do with the nature of the relationship. The ER of the fund goes to run the reinsurance company they are running, negotiating and managing the relationships, of course not only with the reinsurers, but their investors, and of course like all funds the SEC. And they do have many people with deep industry knowledge of the risks who are their to negotiate the risks and evaluate them. Again, what one should be concerned about is NOT the ER, but what return you are earning for the risks, after the ER. And as I explained the math of the income statements shows that SRRIX investors are getting similar returns to the reinsurer itself. And I would add the largest investors in the fund are Stone Ridge employees themselves. It's value that matters. Sure I would prefer a lower SR, and now there is a lower cost alternative in XILSX.

Sorry but don't have any more time to spend on this. If anyone is interested in learning more you can always email me at lswedroe@bamadvisor.com
Last edited by larryswedroe on Sun Jan 12, 2020 10:23 am, edited 1 time in total.

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Re: Gems -- A look back to see what worked--and what didn't

Post by abuss368 » Sun Jan 12, 2020 9:24 am

Taylor Larimore wrote:
Sat Jan 11, 2020 8:03 pm
Bogleheads:

As many Bogleheads know, I have read many books and have extracted valuable quotes from the best books to help Bogleheads succeed. I call these quotes "Gems."

We can look back at older books and see what worked and what didn't. This is one of my favorite books written in 2003 by Larry Swedroe: "The Successful Investor Today--14 Simple Truths You Must Know When You Invest."

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "Knowledge is power, but only up to a point. -- Investors must be extremely selective as to where and how they spend their time collecting information.
Hi Taylor -

Thank you for reminding us. I have always enjoyed the "Gems".

Best.
John C. Bogle - Two Fund Portfolio: Total Stock & Total Bond. "Simplicity is the master key to financial success."

typical.investor
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Re: Larry Swedroe: Rising Rates Increase Worries

Post by typical.investor » Sun Jan 12, 2020 11:15 am

larryswedroe wrote:
Fri Jan 10, 2020 9:46 am
I completely agree that if funds like LENDX and SRRIX were buying publicly available securities the fees charged would be scandalous. Reason is that a passive buy the market strategy should be cheap to run. However, these funds are nothing like that. They are more like the equivalent of an investment in private equity with LENDX running a bank and SRRIX running a reinsurance company. And once you view it from that perspective the fees are much more appropriate.
I see. SRRIX is expensive because it includes the cost of running a company.
larryswedroe wrote:
Sat Jan 11, 2020 5:20 pm
SRRIX does not attempt , like hedge funds in this space do, to guess which are the best risks, believing their underwriters are better. Of course that also allows SRRIX to have lower costs (their costs are much lower than those of reinsurers).

As to same revenue, they don't get exactly the same revenue, because the reinsurers (and SR) recognize that SR has none of the origination expenses and none of the underwriting expenses, and doesn't have the costs of a public company and costs of regulators, etc. So when they negotiate a quota share SR would "cede back" some of the premium.
But then again, it doesn't have the cost of running an insurance company so they have to cede back premiums.

Interesting.

Northern Flicker wrote:
Sat Jan 11, 2020 9:51 pm
With respect to SSRIX, if they cede some premium then any timing risk can in any case just be absorbed into valuation risk. Whenever they get a quota, they have to get it at a fair price. They are going toe-to-toe with big reinsurance companies with armies of actuaries. If SSRIX doesn’t have their own actuaries to price the liabilities, I am not fully confident I’d be getting a fair deal, and lack the visibility or expertise needed to do the determination myself. What are they spending the high ER on if it does not include an actuarial analysis of the value of what they are buying?

I will pass.
That is my concern too. I have read that:
There was a time when a reinsurance company could hike rates significantly and expect to earn back what it had lost in just a few years, even one year in some extreme cases.

But the reinsurance market of the future is one where accounting for expected loss costs within your pricing is going to be key, to ensure that you’re out in the market with a product (capacity) that is sustainable over the long-term and will be there after losses occur, even when you can’t earn it all back immediately.
It seems that unless SSRIX has the same expertise, that they will be increasingly at a disadvantage. It doesn't seem like a matter of simply forgoing some premium due to operating costs, but rather knowing how much $$$ from today's premium is going to be needed to cover future losses. As Larry says, the original insurance company has the tail risk that they need to account for, and can't rely on after event hikes to necessarily cover things.

Then there is also the issue of pressures when money flows into the space and there is overcapacity. Obviously the cedants would be able to get a better deal than SSRIX when other investors are eagerly waiting in the wings.

Bastiat
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Re: Larry Swedroe: Rising Rates Increase Worries

Post by Bastiat » Sun Jan 12, 2020 12:23 pm

Random Walker wrote:
Fri Jan 26, 2018 10:58 am
http://www.etf.com/sections/index-inves ... nopaging=1

In this article Larry discusses the widely held expectation that the Fed will increase rates during the coming year. He distinguished between knowledge and information. Information held by everyone else is of no value. Bond market is extremely efficient. Larry makes the point that some investors have increased their equity allocations in the face of low interest rates. It’s worked out well for them. But judging a strategy on outcome is a mistake; an alternative history could have easily played out. One should not let interest rates dictate one’s equity allocation.
At the end of the article Larry discusses how four alternative funds might fit into a portfolio. Currently equities have historically high valuations and low future expected returns. Many are concerned about rising interest rates causing a bond bear. These alternatives have expected returns about same as equities, SD about half that of equities, no correlation to stocks, bonds, or to each other. One can create an alternatives position by taking from equities, bonds, or some of both. It one takes from equities, portfolio expected return about constant, volatility decreased, Sharpe ratio increased. If one takes from bonds, portfolio expected return increased, volatility increased to a lesser extent, Sharpe ratio increase expected. In both cases portfolio efficiency improves.
Larry’s new edition of Black Swans is coming out soon, and he will surely go into some good detail on the potential improved portfolio efficiency obtained through these alternatives.

Dave
I have been very pleased with the "low future expected returns" of my index investments since this was written. 2019 provided 6 or 8 years worth of the "4-5% expected returns over the next ten years" these prognosticators have been bleating about for the past however many years.

All of the other funds mentioned for which I could find data have significantly lower returns, with some having a negative return. That phenomenon is not limited to the two year period, but indeed seems to apply to each fund since inception.

We'll see what happens in the next bear market, past performance and all that, but I'm very happy paying exponentially lower fees for such "performance".

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by larryswedroe » Sun Jan 12, 2020 12:49 pm

typical investor
But then again, it doesn't have the cost of running an insurance company so they have to cede back premiums.
Sorry but you have misinterpreted what I said, or tried to say. Let's try this, an insurer has more costs than a reinsurer because they have the costs of originating the business. The reinsurer doesn't have those costs. And so when it buys risks it likely isn't getting the full premium the insurer was paid. Doesn't mean they don't earn same profit. And SRRIX doesn't have ALL the costs of a reinsurer whose operating expenses, including all the actuaries needed, and all the costs of negotiating the contracts and all the costs of running publicly owned companies, and so on. SRRIX has lower costs because they don't need all of the same people.. The reinsurers are willing to accept a lesser return on the business they cede to SR because that still allows them to add more business than their capital can support, and because their marginal costs are much lower than their average costs, their net profits rise, even though the profit margins smaller on the business they cede. SRRIX on other hand can cede back some of the premium for two reasons. First it doesn't have the tail risk (it can only lose the amount invested) and two it doesn't have all the costs that the reinsurer has. So both parties win.

SRRIX has the same expertise as the reinsurers, just as the do in LENDX having the same expertise as the banks, as they hire people to run the businesses who did just that for reinsurers (and banks) in prior lives. It's not at any disadvantage as it is a strategic partner as I explained, buying a pro rata share of their risks. And as a large player they are at advantage in negotiations, not disadvantage as reinsurers need to know they have reliable long term capital partners. That is why they engage in quota shares, and not do only one off deals like with what are called XOL transactions (or excess of loss) which are put out to bid. Or sell as CAT bonds.

Finally, this issue of overcapacity is interesting in how people think about it regarding say a fund like SRRIX and ignore it when comes to other assets. This happens to ALL risk assets, it's how you get bubbles in stocks, dividend paying stocks, tech stocks, and so on. Risk premiums are time varying in all risk assets. And capital flows in and out. And premiums rise and fall. While what you hear a lot about is overcapacity in resinsurance premiums are rising dramatically and the no loss return to SRRIX is now about 6% higher than it was just 3 years ago. With the same risks.

Best wishes
Larry

Not Jacob Fugger
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Re: Larry Swedroe: Rising Rates Increase Worries

Post by Not Jacob Fugger » Sun Jan 12, 2020 1:09 pm

Larry Swedroe —

Thanks very much for taking the time to explain this. I am mostly a lurker but writing to say that posts like yours are incredibly meaningful to me (and probably a lot of others). Regards, NJF

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by larryswedroe » Sun Jan 12, 2020 1:29 pm

Not Jacob
Thanks for taking the time. Just trying to make sure people make informed, vs. uninformed decisions, basing on things they think/believe but are not factually accurate. And feel free to email any time.
BTW, here's a more simple way to think about expenses and expense ratio. Roughly the insurer's have operating expense ratio of about 1/3 of premiums they buy. The ER of SRRIX is about the same 1/3 of net premiums they buy. Note that if the figures are the same, SRRIX has a higher ROE because it doesn't have the tail risk so the reinsurer has to hold more capital against the risks.

I would note also that due to the recent losses capital has fled (typical of retail investors) and that enabled SRRIX to negotiate more favorable terms when the contracts renewed. Reinsurers needed to raise capital (reduce risks) quickly to make sure had enough regulatory capital at year end. Good example of how risk premiums are time varying, just like with all risk assets. Note that reinsurers tend to run toward risks AFTER periods of losses as they know the expected returns now higher--the exact opposite of what retail investors do.
Best wishes
Larry

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by Northern Flicker » Sun Jan 12, 2020 3:26 pm

The ER of the fund goes to run the reinsurance company they are running,
Running a reinsurance company without employing actuaries?
Index fund investor since 1987.

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by larryswedroe » Sun Jan 12, 2020 4:00 pm

Northern, I did not say they don't have any with experience running reinsurance operations and evaluating risks. Of course they have people with very senior backgrounds from reinsurers who sat on the very opposite side of the table they are sitting now. Just that they don't need the same depth of people, nor the same administrative staff supporting them that are required to run a full company that is publicly traded. This is a fund that is basically running on behalf of its clients a reinsurance company, very different. And note again that they are buying a small slice of the very same risks those actuaries at the reinsurers felt good about putting on the books.

Perhaps a problem is that you seem to believe that the reinsurers are making "trades". That is not it at all. The reinsurance company books more business than they have the capacity in terms of capital to hold, just like insurance companies. And as I noted they can sell off that excess capacity at a price that enables SRRIX to make a profit and they can also make a profit because their marginal costs are lower than their average costs. This isn't like one day the reinsurer wakes up and says I no longer like this risk. This is perhaps why you and others are making mistakes about the relationship between SRRIX and the reinsurers.

One last thought. When reinsurers or insurers want to SELL off risks they don't want (or looking to create capacity) instead of working with a strategic capital provider they can also just do a trade in the form of what are called XOLs or excess of loss. They put those out to bid. That is very different than the quota shares in which SRRIX participates. XOLs are typically what hedge funds in the space purchase, thinking they are smarter underwriters. SRRIX really operates like an index fund buying the market in catastrophe risks. So it doesn't need to consider individual risks and decide which ones it wants and which it doesn't. It buys broad slices of very diverse geographic risks and very diverse perils and from many different reinsurers. Basically very "Boglehead" like in wanting to get exposure to beta (in this case catastrophe risk beta), not seeking alpha.

I really don't have more time to spend on this, just happen to be "snowed" in yesterday and today. Hope you find it helpful.
Best wishes
Larry

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by Northern Flicker » Sun Jan 12, 2020 4:44 pm

And note again that they are buying a small slice of the very same risks those actuaries at the reinsurers felt good about putting on the books.
And ceding back premium which means there have to be actuaries on the Stoneridge side evaluating whether they are getting enough premium to cover the liabilities and still make a profit. I’m not convinced there is an actuarial discipline at Stoneridge.

The 5-yr annualized return in the annual report is 3.2%. That is low for a reinsurance business. It is 50 bp/yr below the return over the same period of a stable value fund we hold. I don’t think risk has been rewarded in this timeframe. If this is because variance of 5-yr returns is high enough that this can be construed as an outcome significantly less than expected return, then this is equity-like volatility, which does not increase my interest level.
Index fund investor since 1987.

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by larryswedroe » Mon Jan 13, 2020 9:48 am

Northern, like I said, I don't have more time to devote to this. With that said, first, and most importantly, the fund's recent returns are not due to any poor underwriting or anything else along those lines. The reinsurers they partner with had exactly the same experiences. Just happened like with all risk assets we have period where risks showed up, 17-19, just like what happened in 04-05 when reinsurers had big losses due to 7 major hurricane landings in US alone in just two years, vs. average of 1.5 per year. Then the next 11 years were great returns.
And as noted the team as SRRIX running the fund is ex very senior people from the very firms they are partnering with, with deep risk experience. And as I explained they are taking the exact same risks as the reinsurers, partnering. So if one side has losses the other has the same. And the total costs on each side are about the same percent of premiums.
So ROEs are about same and risks are the same. It's that simple.
No point in repeating the same points I have already made.

BTW, here's article today from Artemis, the best site on web for the industry news https://www.artemis.bm/news/stone-ridge ... cat-risks/. You will note that some investors include other insurance companies.
Larry

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Re: Larry Swedroe: Rising Rates Increase Worries

Post by Northern Flicker » Mon Jan 13, 2020 1:24 pm

Good luck with it moving forward.
Index fund investor since 1987.

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