The biggest risk to a successful strategy might be copycats. Too much money chasing the same thing.
As more and more money pours into the same strategy, the dynamics of asset prices change, and the risk of an unwind grows. The more money, the more violent the unwind could be…especially when debt is involved.
Copycats are not a new concept either. For every Warren Buffett, there are thousands of imitators following his trades, hoping to replicate his past success.
The same is true for any other strategy or financial innovation, however short-lived, that generates an exceptional return. If someone is doing it, and it’s easily replicated, someone else will try it too. Then another and another, until the reasoning behind the initial strategy is lost or replaced with “prices go brrr.” It creates a positive feedback loop that shows up in short-term returns that is, unfortunately, unsustainable.
The latest copycat craze, the crypto treasury companies, harkens back to a time when Wall Street embraced investment trusts in the run-up to the biggest bubble in U.S. market history.
The investment trust was a borrowed idea. They first appeared in Britain in the 1860s. The British trusts experienced their own crisis in the 1890s. But that didn’t stop its migration to America’s shores.
Investment trusts are similar to closed-end mutual funds and were marketed much the same:
The investment trust raises capital from investors by selling its own securities and the proceeds are placed in shares and obligations of business enterprises and governments. It is a legal means for cooperation by large numbers of individuals with relatively small amounts to invest. By banding together, they get greater diversification than is possible for the very small buyer, who acts independently.
Moreover, they are able to keep on the job all the time men of expert knowledge concerning investments, who can change their holdings dexterously in accordance with the shifting of the business cycle.1
Trusts offered investors the opportunity to buy shares in a diversified basket of stocks and/or bonds with small amounts of money that was managed by the watchful eyes of an “expert” (turns out, trusts had the same manager performance problems as mutual funds).
The similarities ended with the investment trusts’ ability to use leverage. In addition to issuing common stock, trusts could issue preferred stock and other debt, which could all be invested in whatever assets the trust managers believed could turn a profit.
Trusts issuing debt to buy stock is no different than you or me using margin loans to buy stocks. The risk is the same: should stock prices tumble, you’re either forced to raise funds to cover margin calls or forced to sell and face almost certain loss.
What differs is a trust has access to more types of debt or can issue more common shares to raise money. As long as the demand exists, they can raise money indefinitely. Demand, however, is fickle. It disappears when you need it most.
Demand was a nonissue in the early 1920s. In fact, it offered the perfect environment for investment trusts:
- Growing demand for stocks,
- Easy access to debt,
- Early days of a bull market, and
- Stock dividend yields higher than bond yields.
That last one was important. Debt comes with a cost. Preferred stocks pay dividends, and debt comes with interest payments. If trust managers could more than offset that cost through dividend income, the trust was in good shape. But if they couldn’t, returns from rising stock prices were needed to offset the rest just to break even on the year.
Unlike today, it was common back then for stock dividend yields to be, on average, higher than bond yields. On rare occasions, it flipped when stock prices rose high enough to push dividend yields below bond yields but it, usually, corrected fairly quickly (it was seen, at the time, as a warning sign of excessive valuations — sell stocks when dividend yields drop below bond yields — up until the late 1950s when it flipped and never flipped back). Luckily, the early 1920s was a ripe opportunity and the few existing investment trusts flourished.
Success breeds imitators. A handful of investment trusts existed in 1921. By 1926, the number was 160. It was around 300 in 1927. More trusts were created in 1928, than existed two years earlier. 1929 saw trusts created at a pace of roughly one per business day, accounting for 30% of issuance that year.2 It’s estimated that investment trusts accounted for roughly 60% of new securities in August 1929.3
That’s almost 600 new investment trusts created from 1927 through 1929, billions in money raised through common stock, preferred stock, debentures, and mortgage bond issuance. Each new trust amplified a positive feedback loop: it increased the demand for existing stocks, appeased the appetite for new common stocks, and kept the “New Era” market bubble alive.
The trouble with copycats, is that it can change the dynamics of markets. When one trust takes on too much debt and buys overpriced stocks, risk is isolated to that trust. When hundreds are doing it, the potential risk is market wide. The higher the leverage and the more overvalued the underlying assets in investment trusts, the higher the risk in the system. It only takes one thing to go wrong to trigger selling by a single investment trust to set off a chain reaction that spills into the rest (To be fair, practically everyone used leverage in the late 1920s to buy stocks, investment trusts compounded the problem).
That risk was realized in October 1929. The market crash was the worst in history. The positive feedback loop, that inflated stock prices, reversed. Stocks plummeted, including investment trust shares. A brief recovery into 1930 ended when the bottom fell out.
The downside of too much debt was realized in that moment:
Since the common stock of an investment trust sustains the whole shrinkage so long as it has value, a decline of only 25% in the value of its assets will destroy the value in the common stock of an investment trust whose senior securities outstanding and liquidating value of common are in the ratio of three or more to one when the shrinkage begins. This is the factor of what is usually termed “leverage” in the financial circles. It works as spectacularly in favor of the common stockholder in a rising market.4
When Phil Carret wrote the above in August 1931, the common stock of most investment trusts traded below liquidation value. (If you bought control of the trust at market price, you could, in theory, sell all its holdings at market price, pay off the debt, and be left with a profit. In practice, buying/selling in such a large volume, impacts market prices).
The market deemed investment trust shares all but worthless. Little did Carret know at the time, things would get worse. The market bottomed 11 months later after a 90% decline from the September 1929 peak.
The lesson that many took away at the time was that trust managers were the issue, not the use of leverage. True “experts” should have seen the crash coming and avoided it, they reasoned.
They failed to think that too many copycats using leverage to buy volatile assets, that reprice by the second, might introduce systemic risks into an uncertain market.
Sources:
- Investment Trusts: Investment or Speculation?, Forbes, September 15, 1927. ↩︎
- The Great Crash, John Kenneth Galbraith ↩︎
- The Lords of Creation, Frederick Lewis Allen ↩︎
- What the Investment Trusts have Learned, Philip Carret, Barron’s, August 31, 1931 ↩︎
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