On bullshit in investing

A guest post by Benn Eifert

The epic crash in stocks and crypto has been the big financial story of 2022. When the Fed raised rates, it exposed a lot of bad investments — as Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.” But it would be nice if investors could recognize the too-good-to-be-true stuff before the big crash, so as not to over-expose themselves in the first place.

Benn Eifert knows a bit about recognizing bullshit in the investing world. He’s the managing partner at QVR Advisors, a San Francisco-based hedge fund. Tweeting from his account at @bennpeifert, Benn has also recently become a star of financial Twitter (or “fintwit”, as it’s known), dispensing a mix of humor, technical knowledge, and criticism of popular investing hype. In this guest post, he focuses on the latter, sparing no criticism for the stars of the recent boom-and-bust.

The opinions expressed here do not necessarily reflect the opinions of QVR Advisors.

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“What bothers me isn't that fraud is not nice. Or that fraud is mean. For fifteen thousand years, fraud and short-sighted thinking have never, ever worked. Not once. Eventually you get caught, things go south. When the hell did we forget all that?” — Mark Baum, The Big Short

“Well of course they're trying to screw you! What do you think? That's what they do. They can make up anything; nobody knows! "Why, well you need a new Johnson rod in here." Oh, a Johnson rod. Yeah, well better put one of those on!” — George Costanza, Seinfeld

The investing industry is ridden with bullshit. The most common and insidious form is over-optimism: offers of tantalizing risk/reward that defy any notion of reality, often based on misinformation or deception. Less common but even more dangerous are outright frauds.

The problem is inherent to the product. Most consumer goods – apples, hotel rooms, laptop computers – are tangible objects or services that you can see, taste, feel, or experience, so you can judge how much they are worth to you. Investments represent claims about some future probability distribution of monetary outcomes which are not literally verifiable. The best an investor can do is form a reasonable judgment about the uncertainty around those claims, based on historical evidence and details about the mechanics of how those claimed outcomes are generated.

The packages can be familiar, fresh, or exclusive. Highly speculative futuristic investments are wrapped in ETFs or SPACs. Ponzi schemes are dressed up as sophisticated options strategies (Madoff) or technological revolution (Terra/Luna). Sophisticated institutional hedge funds masquerade as arbitrage when they simply sell catastrophe insurance. Both retail and institutional investors are targets.

The lines between over-optimism, deception, and fraud are not always bright, and investment schemes can move slowly between those categories over time. Common red flags include:

• Projected returns far above historical equity returns

• Claims of returns significantly exceeding bond yields with little or no risk

• Extrapolation of recent extreme investment performance into the future

• Overly complex investments with non-transparent sources of return

• Perverse incentives for the people selling the investment

Bad actors’ tactics are sophisticated and rooted in psychology. They dangle the prospect of wealth and riches (“phantom fixation”). They launder credibility: legitimization via the backing of authoritative figures. They use social consensus and group psychology to normalize ideas and narratives and pressure people to stop asking questions. They use scarcity or immediacy as a pressure tool (you’re about to miss the big returns; the fund is about to close; ngmi). These are just a few of the techniques uncovered by the Consumer Fraud Research Group undercover investigation of sales transcripts.[1] The FINRA Investor Education Foundation promotes basic diligence hygiene:  learn to recognize red flags, know which questions to ask, and independently verify answers.

Over-optimistic, deceptive or fraudulent investments are over-concentrated in areas of new technology. New technologies are characterized by their uncertainty of success. This requires selling potential investors a narrative about future possibilities as opposed to visible cash flows. That is natural! By definition any novel disruptive technology lacks a track record. Investors who avoid innovative technologies altogether because of this ambiguity ignore the inevitability of change.

However, this inherently ambiguous futurism also lends itself to bad behavior. For example, mutual fund manager Cathie Wood claimed that ARKK’s research showed imminent breakthroughs in artificial general intelligence could accelerate GDP growth from 3-5% per year to 30-50% per year.[2] This is preposterous; the fastest sustained economic growth rates in any country in history are closer to 10%, or close to half that for advanced industrialized nations. Meanwhile, she projected compound rates of return over 50% for her portfolio of popular speculative technology companies, presumably in part based on research like that AGI bit. For a five-year period this implies a 7.6x gain, wildly implausible on an ex-ante basis. This is an example of wild over-optimism and misleading or deceptive investor information. Her mutual funds have generated hundreds of millions of dollars of risk-free fee income for herself while destroying billions of dollars of investor capital in abysmal dollar-weighted returns. Meanwhile, investor inflows into ARKK have continued at a rapid pace.  

Another recent example is the explosion of special purpose acquisition vehicles (SPACs). These are perverse financial structures that enable their sponsors and bankers to sell a company to public market investors and walk away with millions of dollars from the promotion fee and merger fees, even if the investment itself performs terribly and the subsequent investors lose most or all their money. SPACs can merge with dubious companies like Nikola Motors, whose prototype electric truck was famously filmed rolling downhill in its promotional video, despite the CEO’s claims that it was fully functional.[3]

Importantly, SPACs allow their promoters to sell shares to investors without the onerous restrictions on making wild financial projections before a traditional IPO. Research published this year found that SPACs project revenue growth at three times the rate of similar IPOs and public companies, at the 97th percentile of actual realized growth among those comps, and then mostly stop making projections altogether after the merger.[4] Chamath Palihapitiya famously used SPACs as the exit liquidity vehicle for his venture capital investments, promoting them as “democratizing access to high-growth companies”. Meanwhile investors who provided the exit liquidity have lost most of their money as his post-merger SPAC share prices collapsed.

Add a new red flag to the list: use of anti-establishment language combined with selling something. This is a common tool used to manipulate ordinary investors who feel left out of Wall Street’s riches. Never trust a “democratizing X” investment pitch: they’re looking for new marks.

Speaking of [air quotes] democratization.

The nascent cryptocurrency industry is another area bursting with hype around interesting technologies. Again fertile ground for widespread deception and fraud. Algorithmic stablecoins paying eye-watering yields had all the classic red flags. TerraUSD offered 20% returns on a coin pegged to the dollar (and therefore optically low risk), via protocols like Anchor or startups like Stablegains. The protocols ostensibly created revenue to pay this yield via lending out the funds to eager borrowers. However, the demand for loans was much lower than the demand to invest at 20% yield, and the lending interest rate was much lower. In practice, the returns paid out to people exiting the protocol had to come from new inflows at an ever-increasing rate, in a classic Ponzi structure.

It should be self-evident that a 20% low-risk investment return cannot exist. The marketing machine around Terra/Luna deployed the standard playbook, on steroids. Widely followed financial promoters like Raoul Pal of RealVision described the protocol as essentially risk-free.[5] The white paper for the Anchor protocol was written by Marco Di Maggio, a Harvard Business School professor, who purported to use complex mathematical simulations to show how Anchor was robust.[6] Stablegains, a Silicon Valley startup that invested in DeFi tokens and stablecoins, was backed by Y Combinator, one of the most recognizable brands in technology.[7]

Countless other protocols have offered stratospheric yields explained by complex schematic diagrams. Understand this: yield has to come from somewhere. If you can’t understand in simple terms where yield comes from, what risk you are being compensated for bearing, then the yield is likely not sustainable. It rests on temporary venture capital subsidies or from inflows into the protocol from other investors. As the recent crypto crash reminds us, one common source of yield is lending at high interest rates to other crypto investors for leverage. This is “real”, but is it sustainable, or does it require extrapolating past explosive returns in crypto into the future?

Bullshit investments are not only pushed to retail. Large institutional investors have shown repeated vulnerability to slick pitches. The flavor of deception may vary since the diligence committees are more sophisticated, but the red flags are familiar, albeit more subtle, typically relying on complexity to obscure the fraud.

Madoff, the patron saint of audacious fraud, claimed to be involved in complex option-based arbitrage strategies. His stated returns were very consistent, around 20% per year, on tens of billions of dollars, completely unfathomable to any professional derivatives manager. The size and scale of his supposed trading activities were huge, yet no one on Wall Street was trading with his firm, nor custodying his assets. This type of outright Ponzi scheme became more difficult in the institutional landscape after Madoff, as investors increased their operational due diligence standards. Such deception and fraud, urges as reliable as the ocean’s tides, would find more subtle forms.

The Allianz Structured Alpha funds managed tens of billions of dollars of money on behalf of conservative pension funds and foundations. They ran a complicated option-selling investment strategy purported to produce equity-like returns with low risk, hedged against a market crash. The strategy generated considerably higher total returns than any comparable limited-loss option selling strategy like the CBOE CNDR Index. It turned out they were using leverage and simply lying about buying insurance against a market crash while providing doctored risk reports to investors and management. The fuse was lit. They blew up spectacularly in March 2020.[8] The key warning was a complex strategy delivering much better results than reasonably expected based on its description, without performance attribution data that could possibly have been reconciled. The most unsettling part of this horror story was how such a large scale deception could occur under the nose of trusted brand-name asset management firms.

InfinityQ is yet another recent example of sophisticated fund managers duping investors with complex, non-transparent strategies. The firm was involved in the trading of highly complex exotic derivatives with banks, and had both hedge fund and mutual fund products. The types of “risk transfer” trades the firm was known for in the derivatives community – geometric dispersion baskets, corridor variance swap spreads, skew locks – would have typically been expected to lose money during periods of market stress, but reported performance was always strong and consistent. Investors took comfort that David Bonderman’s family office had incubated the firm. It turned out that CIO James Velissaris manipulated computer code in internal valuation models, lied about independent third-party valuation, and forged documents for fund administrators and auditors to avoid discovery.[9] The funds were liquidated in 2021 at a massive loss to investors. Here the red flags were a highly complex and nontransparent investment strategy, which was understood by those in the space to have significant short volatility characteristics, with a track record that was far too consistent.

Bullshit in investing, be it wild over-optimism, deception or fraud, is as old as time, precisely because it is hard to resist the promise of easy returns and to tell the difference between innovation and make-believe.

• The first step in avoiding being taken for a ride is to recognize that you are a mark for people trying to get rich off your money.

• Burn the principle into your brain that financial markets are large and competitive and have a lot of smart people in them.

• Easy money-making opportunities are almost never real; professional mercenaries would have found and exploited them first.

• High returns with low risk explained away by complicated and nontransparent strategies deserve great scrutiny.

• On the institutional side, keep in mind that the world is a relatively small place and tremendous value can be gleaned by asking the views of people close to a particular market or strategy.

• Ask questions; be skeptical; do not assume that just because brand-name firms or authority figures are involved that all is well.

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Correction: This post originally claimed that the venture capital form Andreessen Horowitz had invested money in the Terra/Luna project. It did not. The company Andreessen Horowitz invested in was Dfinity.

[1] NASD Investor Education Foundation, Investor Fraud Study Final Report. https://www.sec.gov/news/press/extra/seniors/nasdfraudstudy051206.pdf

[2] https://www.bloomberg.com/opinion/articles/2022-05-24/cathie-wood-enlists-the-robots-for-a-sleight-of-hand

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

[4] Blankespoor, Elizabeth and Hendricks, Bradley E. and Miller, Gregory S. and Stockbridge, DJ, A Hard Look at SPAC Projections (February 1, 2022). Management Science, 68 (6), 4742-4753., Available at SSRN: https://ssrn.com/abstract=3961848

[5] “The Terra/Luna Hall of Fame”, Financial Times. https://www.ft.com/content/40c06a4f-3586-40be-b5ad-b836b5dcdc0d

[6] https://www.anchorprotocol.com/docs/anchor-v1.1.pdf

[7] https://www.ycombinator.com/companies/stablegains

[8] https://www.sec.gov/litigation/admin/2022/34-94927.pdf

[9] https://www.sec.gov/news/press-release/2022-29

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