One useful intuition of modern finance is that stocks are all kind of the same. Oh they’re not, they’re not, this isn’t true. But lots of stocks are interchangeable to some degree, particularly if you own a lot of them. A fair amount of the returns of many stock portfolios are determined by the returns to the overall market, to industry sectors, and to other well-known factors like value and size. You could construct a diversified portfolio of 100 stocks that is reasonably well correlated with the S&P 500 Index, and then you could construct a diversified portfolio of 100 entirely different stocks that is also reasonably well correlated with the S&P 500.

This is useful in various ways for investing: You can target the broad market return, or you can pick sectors or styles rather than individual stocks. Or you can go the other way, get really good at picking individual stocks, and then hedge out your exposure to the risks that are common to all the stocks. 

But it’s also useful for taxes. The basic rule in the US is that if you buy a stock and it goes up, you pay capital gains taxes when you sell it. If you buy a stock and it goes down, you can deduct your losses on the stock when you sell it. If you don’t sell, there’s no tax impact. (Conversely, if you sell a stock short and it goes up, you have a loss when you buy it back; if you sell it short and it goes down, you have a gain when you buy it back.) 

So if you buy 130 stocks and sell short 30 stocks, and then wait a while, you will probably end up making money on, I don’t know, 120 of your trades and losing money on 40 of them. (Stocks mostly go up.) The ones you made money on, you keep. The ones you lost money on, you get out of: You sell the stocks you owned and buy back the ones you shorted. The ones that you keep, you don’t pay taxes on. The ones that you get out of trigger tax losses. If you have other capital gains — if you sold a house or a business or whatever — then you can offset these losses against those gains and avoid paying taxes. And then you go put on 40 more trades to keep everything in balance, so you can do this again. You have regular tax losses but no gains.

There are, sort of, tax rules against this sort of thing, “wash sale” rules and “straddle” rules. The ideas here are:

1. If you buy Stock X, it goes down, you sell it to realize a capital loss, and then you immediately buy it back, you shouldn’t get to deduct that loss, because you didn’t really sell the stock.
2. If you buy Stock X in one account and short Stock X in another account (or do equivalent things with options, etc.), and then Stock X goes up, you will have a gain in one account and a loss in the other. If you close out the losing account and keep the winning one, you shouldn’t be able to deduct the losses, because they aren’t really losses.

And those rules might cover every case in a world in which every stock was completely uncorrelated with every other stock. But in our world, “if Stock X goes down, sell it and buy Stock Y” is a pretty good substitute for a wash sale, and “go long Stock X and short Stock Y” is a pretty good substitute for a straddle. Or really “Diversified Portfolio X” and “Diversified Portfolio Y.” For the purposes of generating tax losses, one pile of market exposure is about as good as another.

That is probably too glib but not by much. Bloomberg’s Justina Lee reports:

Tax-loss harvesting is the strategy of selling losing investments to offset the tax owed on gains realized elsewhere in a portfolio. It’s a powerful tool deployed often in equity holdings, but it has a key limitation: An investor doesn’t always have losses to harvest. That can be especially true in a US stock market that keeps notching new records after tripling over the past decade.

That’s where a “tax-aware long-short” strategy comes in. The totally legal approach is a mashup of hedge fund and personalized portfolio which uses leverage in an individual investment account to bet on some stocks and against others. The goal overall is to make money, but the method practically guarantees there will also be losses to harvest from some of the hundreds of positions. …

With this portfolio, typically 130% long and 30% short, an investor is more likely to have losing positions and more likely to accrue them quickly.

Just like in simpler versions of tax-loss harvesting, those losses can be realized by selling positions. Cash from the sales is reinvested in economically similar securities (to maintain the balance of the portfolio), while the losses are booked and used to offset capital gains elsewhere. 

And:

Tax long-shorts are more expensive than other approaches, complicated and only really effective for those with significant capital gains. But for investors in the right circumstances they’re “wonderful,” says John West, co-founder of Flatrock Wealth Partners at Newport Beach, California.

“You need to have unrealized capital gains somewhere in your capital stack, generally outside of your diversified investment portfolio,” says the former partner at quant shop Research Affiliates, who has been offering these strategies to clients for a little more than a year. He reckons it works best “if you have a private business you might sell. You have a bunch of low-basis stock and you might sell. You’re a 50-something who wants to downsize your Newport Beach home.” 

Obviously it’s better to buy mostly stocks that go up and short mostly stocks that go down, but if you do enough trades you’ll have a little of everything, and the bad ones are good for taxes.

Intuitively, “bonds are all kind of the same” has to be even more true than “stocks are all kind of the same.” Some stocks are Nvidia; many others are not. But a bond is like “you put in $100 and you get paid $X per year for Y years and your $100 back at the end.” X and Y will vary a bit, but they are known in advance. Your upside is finite and known; your downside is limited. Some bonds are riskier than others — some bonds are issued by safe companies with lots of money and will definitely pay you as promised, while others are issued by unstable companies that might not — but even those risks are pretty standardized with well-known public credit ratings. “One BBB+ bond is as good as another BBB+ bond so just buy whatever BBB+ bond you see first” is not a good investing strategy, and there are lot of credit investors who get paid a lot of money not to do that, but isn’t it kind of plausible? Doesn’t it sound about as right as “stocks are largely linear combinations of factor exposures”?

Historically, though, for a long time there was a view that each bond is a special snowflake and you had to travel to the ends of the earth to get exactly the BBB+ bond that you were looking for. “People were worried about bond market liquidity,” in part because there were so many bonds and how could you ever meet anyone who was looking to sell exactly the same special bond that you were looking to buy? The modern view is that bonds are largely linear combinations of factor exposures so liquidity is just fine. Here’s Bloomberg’s Caleb Mutua on quant credit managers:

Systematic money managers, making fast decisions about corporate bonds to buy and sell using complicated algorithms, have seen their assets more than double over the last year by one measure, according to Barclays Plc strategists. By another metric, there could be $90 billion to $140 billion of funds in these strategies in US high-grade and junk bond markets.

It’s the latest sign of how bonds are trading with growing frequency in credit markets, thanks in part to exchange traded funds. That higher liquidity is allowing innovations that have fueled stock trading for decades, including black-box trading models, to gain more of a foothold in company debt markets as well, according to Barclays. 

“The number of funds and the total deployed assets associated with systematic strategies have ballooned recently,” Barclays strategists Andrew Johnson and Dominique Toublan wrote in a note to clients on Friday. “Up until the past few years, systematic strategies occupied a relatively small corner of the credit market. This has been changing rapidly, and the effects on liquidity and price action are already apparent.”

The shift is pitting investors with technical PhDs against traditional portfolio managers that have business degrees. Systematic investors use computer models to scan entire markets and select securities that fit their strategies. … Because systematic firms look far and wide for investments, they will probably find opportunities others miss, thereby providing liquidity in obscure corners of the market.

There is something beautiful about this: Bond market liquidity was bad because bond investors with MBAs used to be like “well I can only buy the bonds that I know personally,” but now it is fine because bond investors with physics Ph.D.s are like “a bond is just a yield and a credit and I can plug them all into my calculator and buy whatever has a high yield with a good credit, so if you want to sell a weird bond I’ll buy it.” 

Here’s a pretty well-known trade that can generate returns of 1,000% or more in a week:

1. Every so often there are teeny little public companies that are listed on Nasdaq or the New York Stock Exchange, but that have fallen into penny-stock territory. The stock exchanges generally require a company to have a stock price of at least $1 to remain listed, and these companies’ stocks have fallen well below $1. So they are in imminent danger of being delisted, which they don’t want.
2. There is, however, a fairly straightforward solution: The company can do a reverse stock split, where every, say, 5 or 10 or 20 shares turn into a single new share. Let’s say the number is 20: If you owned 100 shares before the reverse split, you own 5 shares afterwards. Dividing the company into fewer shares should make the price of each share higher: If the stock was at $0.40 before, after the 1-for-20 reverse split it should be at about $8. (Not much science on that: These stocks are pretty volatile, so after the split it might be at $4 or $12, but it should be some multiple of the pre-split price because each share now represents 20 times as much of the company.)
3. But what if you owned, not 100 shares, but one share before the split? Do you own 0.05 shares afterwards? Fractional shares have become much more accepted as a matter of brokerage accounting, and it’s possible to own 0.05 shares of some stocks in your brokerage account. But most companies’ official shareholder registries do not have fractional shares: If you are an official holder of record of stock, you have to own some whole number of shares.
4. So it’s a fairly common convention, in these situations, to round up fractional shares: If you have 19 or 11 or one share before the 1-for-20 split, you get one whole share after. [1]
5. Thus the trade: You buy one share for $0.40 just before the record date for the split, and then you are given one whole share after the split, which should be worth $8, give or take. That’s a return of $7.60 on your $0.40 investment, or about 1,900%, for maybe a week of exposure.

Nothing here is investment advice, and I cannot guarantee that this will work out for you as advertised, but it is a popular strategy and you can find websites and Reddit posts about it. I trust you see the main problem with it, though, which is that it doesn’t scale particularly well. The trade is buying one share of stock for less than $1 and then getting back five or 10 or 20 times as much stock, for a return of five or 10 or 20 times your investment. But “one share” and “less than $1” are critical parts of the trade. In my example you make $7.60. If you try to do this trade 1,000 times to get $7,600, it doesn’t work: Buying one share gets you $7.60 of free money, but buying 1,000 shares gets you a nice even multiple of 20 shares and no free money at all. Opening 1,000 separate brokerage accounts to do this 1,000 times … look, I’m sure someone has done it, and probably described it in loving detail on Reddit, but it seems tedious.

I guess you could just have a brokerage account, keep like five dollars in it, set up an alert for every reverse split, buy one share of each of them, and make, I mean, probably a number of dollars per month that is greater than $1 but less than $20? For a fair amount of effort? But perhaps a very satisfying $20 a month, $20 a month found in some of the mustiest couch cushions of modern financial capitalism.

In the limit you can imagine teeny penny-stock companies going into their reverse splits with some normal-ish penny-stock list of shareholders (insiders, retail, etc.), and coming out of the splits with a new shareholder base consisting mostly of thousands of retail reverse-split arbitrageurs, each of whom owns exactly one share. I would love to be the chief executive officer of a tiny company whose shareholders are exclusively reverse-split arbitrageurs; I feel like they know how to have fun. I guess they’d all sell the shares immediately though, never mind.

Anyway Upexi Inc. is a teeny Nasdaq-listed company that is in various sorts of listing trouble with Nasdaq and did a reverse split to address some of them. Here is a funny press release from Upexi on Friday:

Prior to the Company's required announcement regarding the reverse stock split on September 27,2024, Upexi estimates there were less than 5,000 shareholders of record. Post-split 5 Brokerage firms have requested roundup shares equaling approximately 199,059 shares of the Company's common stock out of a total of 202,183 round up shares of the Company's common stock requested.

The 202,183 roundup shares requested is approximately 19% of the Company's outstanding shares of common stock post-split and represents an increase of approximately 40 times the number of individual shareholders owning the Company's common stock. The foregoing activity appears to have occurred during the 3 day trading period between the reverse split announcement and the effective date of the reverse split.

The Company and its legal team are currently reviewing the foregoing trading activity to determine if such activity involved possible stock manipulation.

Allan Marshall, the Company's Chief Executive Officer, stated, "The Company intends to pursue this issue to the fullest extent necessary to protect the Company's shareholders exposed to the issue and to help other listed companies to avoid this issue going forward."

Obviously if they find one guy who set up 200,000 brokerage accounts to buy 200,000 pre-split Upexi shares (for something in the neighborhood of $40,000) and turn them into 200,000 post-split Upexi shares (worth $1.6 million as of Friday’s close) then I will be impressed. We talked last month about a guy who found a way to make a few bucks a month via a Spotify arbitrage, and then scaled it up by having bots open thousands of Spotify accounts; this would be the brokerage version of that. But it’s also possible that it’s mostly individual retail traders doing this to make a couple of bucks.

I kind of feel like that is a fair, though arbitrary, punishment for falling into penny-stock territory. Formally, having a stock price below $1 will get a company delisted; practically, companies can often avoid that fate with a reverse split. (This is controversial and in fact the exchanges have proposed rules to limit the number of reverse splits companies can do to stay listed.) But the reverse split comes with its own weird punishment: You have to pay away 19% of your stock to retail reverse-split arbs as a tax on being a penny stock. 

“Stocks are all kind of the same” is a pretty useful approximation but it has broken down recently due to big tech. The Financial Times reports:

Just five large companies — Nvidia, Apple, Meta, Microsoft and Amazon — have contributed about 46 per cent of the year-to-date gains for the S&P 500.

“It’s a very difficult situation for active managers,” said Jim Tierney, chief investment officer for concentrated US growth at AllianceBernstein. “Normally having a position at 6 or 7 per cent of your portfolio is as far as most portfolio managers would want to push it for a business you have real conviction in. The fact that would now be a neutral weight or even underweight, it’s an unprecedented situation.”

At the end of September, Fidelity’s $67bn Blue Chip Growth fund, which is benchmarked against the Russell 1000 Growth index, had more than 52 per cent of its portfolio in large positions — Nvidia, Apple, Amazon, Microsoft, Alphabet and Meta. BlackRock’s recently launched Long-Term US Equity ETF also had 52 per cent of its assets in holdings worth more than 5 per cent of the portfolio as of last week, according to data from Morningstar. 

That’s from a story about US tax concentration rules, which penalize mutual funds whose portfolios are mostly (50% or more) made up of concentrated positions (stocks each representing more than 5% of the portfolio). In the olden days you’d buy 50 stocks and they’d each be around 2% of the portfolio and it was fine; for stocks you really loved you’d maybe stretch to 6% or 7%. These days, the market mostly loves those big tech names, so just a neutral weighting — just “I think Nvidia is fairly priced” — would give you a ton of Nvidia. And those big names are where all the growth is, so omitting them is painful.

One model of Tether and its stablecoin, USDT, is something like “Tether is like a bank with no capital requirements, minimal regulatory oversight, a history of doing weird stuff, and it doesn’t pay interest.” This model seems bad. I mean, good for Tether, but what is the appeal of this? Why would it be a thing?

Another model of Tether is something like “cryptocurrency trading is a fun casino game and USDTs are the chips you use in the casino.” This model is fine, but not that inspiring. If you are betting on crypto it is helpful to believe that crypto solves some real-world problem. These days when people talk about real-world use cases for crypto, they tend to start with stablecoins (like USDT) as a tool for payments. “USDT is a necessary tool for speculating on useful crypto projects” could be a good story, but if the main useful crypto project is Tether then that doesn’t work.

A third model is something like “Tether is a way to send US dollars that is faster, more technologically sophisticated and more convenient than using the regular US banking system.” This model is the most straightforward real-world bull case.

But a fourth model is something like “Tether is a US dollar-denominated alternative to the US dollar financial system: It works a lot like dollars, except that, unlike the rest of the dollar system, it is not subject to the whims of the US government.” This model seems … interesting. This model, I think, describes a niche that could provide a lot of value, and that a lot of people want. We have talked recently about the demand (among Russia and other not-aligned-with-the-US countries) for an alternate payment system, and about Tether’s pitch to commodity trading firms as a way to finance global trade. I wrote that one “possible bet is ‘if the US government keeps weaponizing the dollar, someone will invent a better dollar, something that is fully interchangeable with the dollar but that is not subject to US government policy.’ What if it’s Tether?”

Obviously the problem with this model is that the US government likes having the dollar financial system subject to its whims. Also, like, I say “whims,” but some of the whims include “not financing terrorism”; you might like the whims. Anyway the Wall Street Journal reports:

The federal government is investigating cryptocurrency company Tether for possible violations of sanctions and anti-money-laundering rules, according to people familiar with the matter. 

The criminal investigation, run by prosecutors at the Manhattan U.S. attorney’s office, is looking at whether the cryptocurrency has been used by third parties to fund illegal activities such as the drug trade, terrorism and hacking—or launder the proceeds generated by them.

The Treasury Department, meanwhile, has been considering sanctioning Tether because of its cryptocurrency’s widespread use by individuals and groups sanctioned by the U.S., including the terrorist group Hamas and Russian arms dealers. Sanctions against Tether would generally prohibit Americans from doing business with the company. …

Tether is the world’s most traded cryptocurrency, with as much as $190 billion changing hands each day. It is also a vital financing tool for several of the U.S.’s top national-security concerns. These include the North Korean nuclear-weapons program, Mexican drug cartels, Russian arms companies, Middle Eastern terrorist groups and Chinese manufacturers of chemicals used to make fentanyl, The Wall Street Journal has previously reported. ...

Tether said it had no indication the company is facing a broader investigation. “To suggest that Tether is somehow involved in aiding criminal actors or sidestepping sanctions is outrageous,” the company said. “We work actively with U.S. and international law enforcement to combat illicit activity, as we’ve publicly demonstrated many times.”

It is a fine line; “we are a way to send dollars without quite as much interference from the US government” is a good pitch, but not if the US government hears it.

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