Read the whole article here: The Commodity Futures Risk Premium: 1871–2018
From the Archives
After this great tweet from Jerry Neumann on good business writing, I was reminded me of this 19th century book attempting to tackle a similar topic. While Jerry’s focused on emails and more modern documents, this book discusses the original email: letters.
Check out the whole table of contents, but here are some particularly interesting / relevant chapters:
- Sample Bankers’ Letters
- Letters of Recommendation
- 32 Examples of Common Vulgar Expressions
- Letter Answering Inquiry as to Business Standing
Before diving into the usual Sunday Reads, I just want to share an insane piece of history (for me at least) that I found while reading through the archives. In the famous 19th century book 28 Years in Wall Street, there is a passage describing one of my relatives turning down a job from Jay Gould that would’ve involved being an informant during Gould’s infamous Gold corner in 1869. Crazy stuff!
Okay, now we’ll resume our scheduled programming…
This week’s edition of Sunday Reads dives into some of the innovative and wacky investments that financiers have used over the centuries. Some of these have persisted in one form or another, while others died off… *cough* Ostrich feathers *cough*. Enjoy this dive into the world of investing in literal children, holy corpses, Ostrich feathers, inflation indexed bonds, subprime mortgages, and more.
What do you think today’s crazy asset will be when historians look back in a hundred years?
Throughout history, low interest rates and yields have often spurred innovation in financial products and assets as investors hunt for income. In terms of creativity, there is perhaps no better example of such innovation than what this group of Genevan bankers created in the 18th century.
“In the 1750s and 1760s flat-rate pricing [of annuities] had relatively little impact on the total cost of government borrowing because most life annuity purchasers continued to be adults who bought annuities on their own lives, their spouses’, or their adult servants’. The flat-rate prices gave near-market yields on adults around the age of 50. Older adults were discriminated against by the flat-rate prices. There were few major alternative suppliers of life annuities, so the government may have profited from public demand for assets to smooth out life-cycle consumption.
To earn a higher yield, annuities had to be bought on the lives of children. There was no legal restriction on naming third parties as contingent lives. The two main impediments were (1) the risk that all the income would be lost to the investor if the third party died and (2) the transaction costs involved in documenting survival of the third party every year to collect the annuity.”
In other words, there was a mis-pricing opportunity in buying annuities on children, since their young age provided a higher yield with less risk. Also, importantly, regulation at the time allowed bankers to purchase annuities on someone else’s life. Meaning these bankers could pick and choose children to buy annuities on as an alternative source of high-yielding income. So what did the Genevan bankers do?
“The technical solution to the problem of investing on children’s lives emerged in the early 1770s in a famous scheme known as the “trente demoiselles de Geneve.” It began as the exclusive domain of Genevan banks, through their branches in Paris. The banks developed lists of young girls from Genevan families to name as contingent lives. The families were selected for their record of health and longevity. The girls were mostly between the age of five and ten, and were selected only after surviving smallpox (or after inoculation, which was introduced in the 1780s). The Genevan banks purchased large amounts on each life to reduce transactions costs, but pooled together annuities on enough different lives to reduce the risk. The most common number of individual lives in a pool was 30, hence the name of the scheme.’
Most interestingly, however, is what happened next. Once the bankers had pooled together 30 annuity contracts on these young children that were deemed healthy, they sold tranches of the pooled securities to other investors seeking income.
“The banks resold small fractions of their pools of annuities to individual investors and usually collected the annuity for them. They restructured the dividends into other packages, including tontines.”
Today, the term “subprime mortgages” is synonymous with the Great Financial Crisis of 2008. However, this article focuses on a different set of subprime mortgages: 18th Century Plantation mortgages.
“It was in the second half of the 18th century that the growth in the number of plantations had really taken off. This was made possible by the 1753 financial innovation called the negotiatie, a type of mortgage bond in which a fund director would raise money with investors in the Netherlands, to provide a mortgage on a plantation in the West Indies. Investors gladly furnished the required capital, attracted by the handsome return of 5 or 6 percent that the fund directors promised. The fund manager benefited as well, as the planter was obliged to send his commodities to the director and often had to attract all his supplies from the same man too– on all of which he paid a commission fee. Viewed this way, the system seemed to benefit everyone.”
As in 2008, however, the system inevitably went south:
““In the second half of the 18th century a tremendous flow of cheap credit went to the Dutch colonies in the West Indies, allegedly turning all who desired into real planters. All this credit allowed many to acquire an estate, but often together with deep debts that turned out too high to repay… Just like in recent times, the mortgages turned out to be subprime and carried far more risk than expected. Heavily indebted planters lost their estates as they could not pay their debts, and the financiers saw their investments go up in smoke.”
While Treasury Inflation-Protected Securities (TIPS) were first auctioned in 1997, the concept of inflation indexed bonds has existed in the United States since our nation’s founding. In this article, Robert Shiller discusses the history of inflation-indexed bonds, and their relation to the Revolutionary War:
“By the late 1770s, when these first inflation-indexed bonds were conceived and designed, the U.S. War of Independence was in a difficult stage. In 1779, the British Army had just captured the state of Georgia and had taken Charleston South Carolina. The eastern seaboard of the United States was blocked by the British Navy. The morale of the United States Army was low: They were poorly fed, poorly clothed, and often sick. The morale was so low that, as we now know, there were actual army mutinies in 1780 and 1781. There was real concern in 1779 that it would be impossible to keep an army if something were not done to address the loss of value of their pay. The invention of indexed bonds came in response to this very real and dangerous crisis.”
In a previous article, I discussed investing in the beer industry, specifically the late 19th century Guinness ‘IPO’. However, this paper covers investing in beer’s more sophisticated counterpart: Wine. I will confess that I didn’t think this article would be anything too thrilling, but it turned out to be a fascinating read on an area of investing that I truly knew nothing about. Well, put simply, Christie’s held it’s first “wine only auction” in 1769, and the rest is history.
This paper analyses 36,271 wine prices from 1900 to 2012, and calculates the returns of this niche asset class. The authors find that from “1900-2012, we estimate a real financial return to wine investment of 4.1%, which exceeds government bonds, art, and investment-quality stamps.” Quite the claim. However, much of the high-net worth investment world are already well aware of this ‘asset class’ offering an attractive alternative investment, with a Barclays report claiming roughly 25% of the global High-Net Worth population own a wine collection, and it represents about 2% of their wealth. There are even a number of wine funds dedicated to investing in this area, but more on that in a minute.
The most interesting aspect of this paper is the quantitative approach it takes to measuring the predictors of wine’s returns.
“Presenting a simple and stylized model of price dynamics… the model proposes that, in general, a wine’s fundamental value is governed by the maximum of three measures:
- The value of immediate consumption.
- The present value of consumption at maturity plus the non-financial ownership dividends received until consumption.
- The present value of lifelong storage (i.e., the value as a collectible).”
In line with this ‘factor-esque’ approach to investing in wine, Quality is a significant determinant of performance, as one would imagine. “The model delivers different predictions for the price patterns of low-quality and high-quality wines (or vintages) over their respective life cycles.
“High-quality vintages appreciate strongly for a few decades, but then prices stabilize until the wines become antiquities [collectibles], after which prices start rising again. For low-quality vintages, prices are relatively flat over the first few years of the life cycle, but then rise…”
In other words, a low-quality wine initially lose money, since there is little ‘consumption value’ (a.k.a it tastes bad), but prices eventually go up over time as the wine becomes attractive for it’s value as a collectible. Conversely, high-quality wine gains money out the gate, and continues this trend for roughly 40 years while its ‘consumption value’ increases as the wine ages to a certain point of maturity, when prices then stabilize. However, like the low-quality wines, the high-quality wines then increase in price again as they become attractive for their value as a collectible.
The two chart’s below sum up this dynamic perfectly:
The article is filled with analogies for investment lessons and principles today. Consider the below excerpt:
“We should expect that trading volume at auction stays high for a longer time for a good vintage, as these bottles are best consumed at a later age. Dealers may also cater more explicitly to wine drinkers, and therefore sell a wine from a poor vintage at a younger age than a wine from a good vintage.”
To me, there is a clear analogy to investing in high-quality companies over a long time horizon, versus trading low-quality companies in the short-term. Sticking with the analogy, this would particularly apply to buying the stocks of new public companies after they IPO. The performance of different wine vintages also sounds very similar to Value investing, as the authors state: “highest returns [are] observed for maturing high-quality wines.”
While you should certainly read the whole paper, I will offer one last fascinating excerpt about the soaring returns in World War II:
“Wine prices did not increase in real terms over the first quarter of the 20th century… [but] the value of wines boomed during the Second World War; prices increased by more than 600% between 1940 and 1945. Many factors probably played a role: the war upset the trade in high-end French wines, with the port of Bordeaux and many châteaus occupied by Nazi Germany; the U.K. government prohibited sales of wines and spirits by unlicensed auction houses; Christie’s had to limit its sales activities after its main offices were bombed; and many wine bottles were sold through Red Cross charity auctions that are not included in our data but may have pushed up price levels. The boom was followed by sharp decreases in wine valuations in the years after the end of the war.”
But what about the market today? After I finished reading this paper, I was curious to find the answer to this question as well, and discovered that there is a Wine Stock Exchange of sorts, and numerous investment funds dedicated to this niche market. The exchange has multiple indices tracking different sections of the wine market, and some of the returns in recent years are staggering:
However, there is evidence that active management is even suffering in this area of the market, as I checked out the returns of The Wine Investment Fund since its strategy’s July 2013 inception…
If enough participants believe in the value of an asset, then the asset holds value. This could only be true across a very short time period, but holds true nonetheless. Throughout history, there have been some strange bubbles in ‘assets’ like beanie babies, ostrich feathers (see next article), and tulips. In Medieval Europe, the strange asset du jour were corpses. Yes, corpses. Specifically, the relics of saints and other holy religious figures.
“There has long been a tension in Christianity between economic concerns and providing a way to commune with the sacred. Nowhere was this more apparent in medieval Europe than with the bodies of holy persons (saints’ relics). These bodies provided pilgrims with a focus, allowing them to direct their devotion to heaven by praying over the relics. But these bodies were not only sacred objects: they were also bought and sold for profit by enterprising merchants and monks who created vast trading networks throughout Western Europe to exchange them.
Because they were human bodies, relics held a special position in the medieval economy. Their value was based in part on their connection to the spirit that had once inhabited the body, or the personality of the saint. But because they were objects (and often highly mobile objects too), relics were commoditised by medieval society – traded, bought and sold for profit by the communities that held them.”
I wrote about this wild story here.
Here’s a fun fact for you:
“When the Titanic sank in 1912, the most valuable cargo on board was a shipment of feathers that was insured for $2.3 million in today’s money because in 1912 only diamonds were worth more by weight than feathers. And the reason for this was the hat craze. Everyone needed hats with feathers on them, and they needed to be super big and fluffy, and sometimes people would have entire birds on their hats.”
To be honest, you just have to read this article to really understand what’s going on. How can I explain a bubble in Ostrich feathers?!
If you want to read more about bubbles involving animals, this Winton article is fantastic.
“Contracts for future delivery of commodities spread from Mesopotamia to Hellenistic Egypt and the Roman world. After the collapse of the Roman Empire, contracts for future delivery continued to be used in the Byzantine Empire in the eastern Mediterranean and they survived in canon law in western Europe. It is likely that Sephardic Jews carried derivative trading from Mesopotamia to Spain during Roman times and the first millennium AD, and, after being expelled from Spain, to the Low Countries in the sixteenth century. The first derivatives on securities were written in the Low Countries in the sixteenth century. Derivative trading on securities spread from Amsterdam to England and France at the turn of the seventeenth to the eighteenth century, and from France to Germany in the early nineteenth century. Circumstantial evidence indicates that bankers and banks were at the forefront of derivative trading during the eighteenth and nineteenth centuries.”
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