Optionality is good

February 17, 2023

It's the start of the year and that means we have to get real work done in this newsletter. In the late fall it may slide into lethargy and ridiculousness but not now.

Optionality matters in finance. Optionality, otherwise known as freedom, gives you the chance to do something else that is better with your money. It's critical in an economy as well - optionality enables capital and labor flow to better ideas and higher sources of return.

One way that financial firms make a lot of money is to take away your optionality. Things like annuities often have severance charges, and headlining the news recently is the disaster around private REITs. We have many clients who are trying to redeem private REITs (that we did not place them in), and they are finding the boards of these firms are disallowing distributions. When you want your money back, they are saying "No, not today. Our investments did not go well and because we're private there is no market for you to see the real price, but if you redeem we'll have to show you. So can you come back later and fill out a massive pile of paperwork again and we'll do everything we can to slow it down then as well?"

There are some cases where the loss of optionality is clear and compensated. If you buy a bank CD, you likely will get a higher rate than a savings account, because you are giving up the option to withdraw from the CD without a penalty. This is ok, as the bank gives you value in a higher rate and you give the bank predictability and it's clear that this is the exchange. (1)

Here are four examples of optionality loss:

1. Sometimes you can lose optionality inadvertently. For example, if a fund that you own does not have enough liquidity in a severe down market, you may lose money as you trade out of it, particularly if it is a big position. This is known as a "roach motel" in finance: you can enter, but you cannot leave. (2)

2. Other times you can lose optionality through friction. This is one of the favorites of the industry: deny transfers on technicalities or throw enough paperwork at people that they give up. This is called "sludge" and the practical reality is that it stops assets moving to areas of higher return.

3. A third area where optionality is lost is in taxes. You'll notice I don't talk about taxes too much in this newsletter because everyone's blood pressure goes to 180/120 for different reasons, but in this case it's too interesting to resist. When you raise the capital gains tax rate, you restrict capital from finding a more efficient home. So if you were the CEO of a big, old mutual fund company, and you want to keep your profits high, a capital gains rate increase is going to help you and hurt the disruptor. Ideally this rate goes to zero so there is no artificial friction and capital, and hence labor, can move to the source of highest return. But then there is a societal wealth inequality issue to deal with (the capital compounding effect), and that makes things more complicated.

4. A fourth example is a gift card. Take the Starbucks card as an example. Last summer the coffee chain had over a billion dollars sitting unused on its gift cards. Starbucks uses its customers' money as financial float and about 15% of the coffee credits are never claimed. And it's certainly not easy to reverse a gift card.

To the extent things are in our control, we're not giving up optionality for clients. Generally we don't do it at all, but in certain cases where it comes up we want the client compensated.

Dan Cunningham

^{1. It doesn't make much sense to buy CDs today. You can make more money in a 1-Year Treasury, with more liquidity / optionality, and generally a better tax rate, than a CD. So there's really no reason to do it. Talk to us.}

^{2. There are ways we believe we can use the roach motel problem to benefit clients over the long term.}