jankythoughts2

Foreword

The SPX just had its worst week since 2020. You know, the year where everything shut down. Because of tariffs that everyone was warned about, for almost a year now. What happened?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Boom! Tariff the World

After the market closed slightly up on Wednesday (4/2/2025), the president announced the actual tariffs that he and his team have been talking about for months (since before they were elected).

Despite having been forewarned about the tariffs for almost a year, the next day (4/3) markets dropped the most in percentage terms since the early days of 2020 around the start of the pandemic, and dropped even more the day after (4/4). Combined, this is the largest weekly percentage drop of the SPX since the chaos of early 2020, and the largest absolute 2 days points drop ever.

Tariffs He Wrote

Despite the tariffs being announced well ahead of time, it was still shocking because the administration had been touting a “reciprocal tariff”, but when the details were revealed, what actually happened was anything but.

Reciprocal tariffs on most nations would amount to at most 10-20% for most items with a large number of items excluded. Instead, the administration went as far as to tariff effectively every nation by at least 10% for all imports, with some going as high as 50%. To justify the tariffs, the administration came up with what looks effectively like bogus tariffs the nations supposedly charge US exporters, even claiming that an uninhabited island populated mainly by penguins is charging tariffs on US exporters. I guess they don’t really like US fish?

After many commentors cried foul, the administration finally came clean and noted that the supposed tariffs imposed by other nations on US exporters is really just the ratio of US trade deficits to US imports from the country, with a 10% minimum cap.

To be absolutely clear, as many journalists, economists, financial advisors, finance professors and commentors have noted, this equation is utter bovine feces — despite dressing up the explanation with fancy maths symbols (that mean nothing!), the equation is meaningless in both economics and finance, an entire fabrication out of thin air.

Trade Deficits

In this one, incredibly unsophisticated, move, the administration has shown that it is deeply concerned about US trade deficits. So let’s talk about that for a while.

To simplify somewhat, a trade deficit is when a country (USA in this case) exports less to another nation than it imports from that nation. The deficit is simply the dollar amount of the difference between exports and imports to/from that nation.

As a general rule, deficits between 2 nations is a non-issue. Since trade is global and bilateral between different nation pairs, it is inevitable that there is an imbalance in trade between any 2 nations pair.

For example, Madagascar exports mainly vanilla beans to the USA, something that does not grow very well on American soil and climate, and so the USA has no real vanilla bean industry. However, because Madagascar is so poor, with the average person making just over $500 USD a year, there simply isn’t a lot that the average Madagascan can afford, and thus they simply don’t import a whole lot from developed nations which generally produce higher value added, and higher priced, goods — when you make $500 a year, an iPhone really isn’t something you think much about.

In theory, this trade deficit “goes away” when we consider the entire world. Let’s say the US imports a lot of Chinese stools, but exports a relatively smaller amount of tables to China — the US has a trade deficit with China. In the idealized Econs 101 case, this is fine because, in theory, the US will have a trade surplus (exports more to this country than the US imports from this country) with a 3rd country, say, Germany. Germany in turn has a trade surplus with China. So while every nation in our 3 nations scenario has a trade deficit with one nation, they also have a trade surplus with another, and the balance of trade (the sum of all trade deficits and surpluses for a single nation) will be 0, or at least very close to 0 over time, for all 3 nations.

In practice, this doesn’t really work. Empirically, we know that most developed nations have been consistently running balance of trade deficits for years, if not decades. There are many reasons for this phenomenon, but a large part of which is what the president said he is trying to address — unfair competition from some countries, such as China, where a combination of state level subsidies to domestic producers and tariffs or other barriers to foreign producers result in extremely one sided trade dynamics.

Face Off

But are trade deficits really bad? Think about it — some country is putting their citizens to work, and putting in their natural resources, to make a product that they then send to us. That country has spent non-trivial amounts of resources to produce that product, and in return, all they want from us is a few pieces of green paper. Green paper that we, as a country, can create almost for free.

In fact, Milton Friedman, a celebrated economist, made this point exactly.

Now, if you look at it from that perspective, it would seem that America should strive for larger trade deficits, not smaller!

Of course, reality is not quite so simple. There are very good reasons why a country would want to have a smaller balance of trade deficit:

• It is painful for those workers who are displaced by foreign goods. Yes, perhaps if you reduce the balance of trade deficit, you’ll incur a larger loss of jobs via not creating jobs in new industries that are never borne as the necessary inputs are never imported (as part of reducing your deficit). But as Milton Friedman notes (in the video above), those displaced are real people, with real voices, while those jobs that you never gain? They don’t exist yet, and thus have no say in the matter.
• If a country allows its industries to atrophy due to cheaper foreign imports, then at some point, expertise for producing those goods will be lost to that country. This means that any future goods based on that product may not be invented in that country simply because it doesn’t have that industry anymore. For example, a country is unlikely to invent the next generation of chips if they don’t even a chips industry.
• There are some products that a country needs in order to be independently strong. For example, steel is needed to build weaponry, and if a country imports all of its steel, then it is at the mercy of whoever sells it that steel — if they cut off supply, and then invades, the country will be in a pretty serious pickle.
• A large and prolonged balance of trade deficit is not sustainable. It may not be an issue in the near term, and problems may not emerge for many decades, but eventually, a country’s trade partners may find that they don’t really care for anything it produces, thus they have no need of its green pieces of paper, so they just cut it off from their goods. What then? Without industries, and without the expertise to restart those industries, the country would be at a dead end.

In summary, while deficits in the short term are good — they improve the average standard of living of the country’s inhabitants, in the long term, they can cause very serious issues for the country as a whole.

Sliding Doors

To be clear — I agree in general that a country needs to protect certain critical industries in order to remain independent and prosperous, and that tariffs are one of the tools to achieve those ends.

However, this needs to be better thought out and implemented. From inauguration day till just before the tariff details announcement on 4/2, the president made around 20 tariff announcements (in around 2 months!), most of which were changed or rescinded completely within days, if not hours. And then, out of nowhere, he announces tariffs that are wildly out of proportion to their stated intent, with what many speculators are saying seems like the output of a particularly bad LLM hallucination.

At the same time, the flipflopping of tariff policies resulted in serious business paralysis. Businesses typically order their inputs months in advance. If they cannot be sure what price they’ll ultimately pay for the inputs (since payment and tariffs both apply after the goods arrive), they simply cannot make any major decisions with regards to their supply chains and operations.

Finally, it is important to recognize that it takes years to build factories and to plan out supply chains. You simply cannot impose a tariff and demand companies shift their productions onshore in order to avoid the tariffs the next day. In the short run, there is nothing a company can do about their current supply chain, so they are forced to pay the tariff, even if they want to onshore their productions eventually.

If the short term goal of the tariffs are indeed to rebuild America’s industries, I’m all for it. But we have to recognize that rebuilding America’s industries is to serve a longer term goal, which is to strengthen the nation and enrich its people. Trying to rebuild industries by creating chaos in the business and international trading landscapes, while simultaneously alienating and insulting our allies is going to isolate America while making it that much harder to do business either domestically or internationally — the exact opposite of the end goal of a strong and prosperous nation.

Inflation

As discussed in Politinomics, tariffs are inflationary. There are some who argue against this, but I believe those arguments are wrong.

Some argue that tariffs are not inflationary because if the imported good becomes more expensive because of the tariff, consumers can simply substitute with domestic goods. This is a flawed argument, because it conflates inflation with inflation measures.

A similar argument is that as foreign goods become more expensive, it’ll trigger a recession, because consumers simply cannot afford to consume as much goods. As recessions are deflationary, the argument then concludes that tariffs are deflationary. Again, I believe this is a flawed argument, for the same reason:

As mentioned in Inflations, inflation measures are very flawed, though they are pretty much the best that we have right now. One pet peeve of mine about most inflation measures is that they usually take a basket of goods at some point in time, then measure the change in prices of those goods over some period of time to compute inflation rates. Most measures use baskets based on what consumers actually buy, which seems reasonable, except that it has a “too expensive” problem.

Imagine that you are currently able to afford to eat out every meal. However, for whatever reasons, restaurants all around the world suddenly raise their prices by 1,000%, though all other goods and services remain at the same prices. After the price hikes, you no longer are able to afford to eat out at all, so instead, you cook at home, which turns out to be cheaper than eating out before the price hikes, though it is not your preference.

In our scenario above, would you say that inflation is up, down or flat? Most people would say that inflation was up, despite the fact that you are now spending less money cooking at home. However, most inflation measures that use the “basket of goods consumers buy” approach will initially register a spike in inflation (due to the 10x increase in eating out costs), until the basket of goods is updated to reflect that you no longer eat out, at which point it’ll register deflation, because now you are spending less money on your basket of goods.

Obviously, this is wrong — inflation clearly went up, the fact that you are no longer able to afford your previous lifestyle is testimony to that.

Finally, the last argument I’ve heard is that tariffs are paid for by the exporters, and that somehow, tariffs are a tax on the exporters and so consumers will not see price hikes. Empirically, this is wrong — multiple goods are forecasted to go up in prices, and multiple companies have stated that they plan to hike prices in response to the tariffs.

The key to remember is this — businesses are commercial ventures, they need to make a profit to survive. There is no business in the world that can survive losing money perpetually (companies that do that are called charities, not businesses, and they are funded by donations).

Now, some may claim that businesses are making so much money, they can afford to make a little less. That argument may sound correct, right up till you look at the details. Most businesses (outside of tech and finance) make profit margins of around 5-15%. Retail businesses, in particular, are famous for having razor thin margins, some as low as 1-3%. What do you think happens if you are making 10% margins, and then a minimum 10% tariff is imposed on the inputs into your businesses? 10 – 10 = 0.

Immediately after the tariffs are imposed, some businesses may be able to raise prices, while others may not raise prices for a while. For example, companies which sell mostly online tend to be able to adjust prices faster, while brick and mortar stores tend to lag because their prices are on physical price tags and it takes a while to manually adjust all the price tags. Similarly, businesses locked into long term purchase orders may not be able to raise prices due to contractual obligations.

However, in the long run, where short run considerations like price tags and time limited contracts are no longer factors, the business can, and literally must (in order to stay alive), raise their prices. These raises may be gradual or fast, depending on the industry, and they may be explicit (prices actually going up) or implicit (reduction in costs due to better productivity not being passed on to customers as price decreases). But one way or another, the business must raise its prices due to the tariffs, or they simply go bankrupt.

Possibilities

So what are the possible outcomes of these tariffs? First, I must say that I am extremely unqualified to discuss this — I have no inside knowledge of how the administration thinks, and obviously I cannot see the future. Also, all of these are extremes — I don’t think any of them will become reality in their entirety, but instead, the final outcome may incorporate aspects of each of these.

Tariff gotcha

Possibly the best possible outcome for America. The president uses the tariffs for bargaining leverage to negotiate better trading terms with the rest of the world, and the tariffs are never actually implemented, or they are only live for a very short (days) period of time.

Soon after the announcements of the tariffs, Vietnam is already in talks with the president to reduce their duties on US goods.

Oh, never mind

The president, willingly or forced, retracts the tariffs without getting a deal with the rest of the world, before tariffs actually go live, or go live for only a very short (days) period of time.

Tariffs are, legally, a tax, and the Constitution endows only Congress with the power to impose new taxes or update existing ones. However, Congress has passed laws in the past which allowed the president to unilaterally impose or adjust tariffs in certain circumstances. It is possible that Congress changes its mind and removes the president’s authority to impose/update tariffs.

Fight club

The tariffed countries retaliate by imposing their own tariffs or other trade barriers, effectively engaging the trade war head on. The fight may spiral with each side escalating back and forth until one side surrenders, or some compromise is reached.

This would be seriously detrimental to the economies of both the US and the countries involved (assuming both sides are a large percentage of trade of the other). There is no winner in this situation, only a loser and a slightly less battled loser.

In particular, the tariffs currently slated to be implemented are already so high for some countries that they are effectively already cut off from the US market. This means that for them, higher US tariffs would make very little meaningful difference, so they may be more inclined to fight.

Given that many goods imported into the US have no other source of readily available producers, this would mean that US consumers will simply be deprived of those goods until new production can be started up somewhere else (or in the US itself), which can take years/decades, depending on the goods.

China has already announced actually reciprocal tariffs on the USA.

New BFFs

The worst possible outcome for the USA, would be if some of America’s largest trading partners decide to cooperate and defend against the new tariffs as a bloc. The new bloc could be used to gain leverage over the US to extract better trading terms, possibly even worse (for the US) terms than existing ones, or, much worse yet, the bloc could effectively trade amongst themselves, cutting out the US entirely.

Canada sent trade envoys to the EU soon after their recent elections (before tariff details were revealed), and rumors are that they are thinking of forming a bloc to better negotiate with the US, or perhaps even to cut out the US entirely.

Fin

Nobody really knows how this will all end. While some countries have stated that they will not contest the tariffs but will instead work towards a compromise, they may change their minds if other countries start getting preferential treatment. At the same time, countries that opted to fight may find the president to be unyielding, and quickly lose their appetite to continue the war.

In the end, this entire mess creates chaos in international trading, a lifeblood of effectively all large businesses and many/most small/medium ones as well. It is no wonder that the markets are treating this as a very serious event, on par with the pandemic.

For now, all we can do is watch helplessly as the leaders of the world try and secure what’s best for their nations, praying that whatever happens won’t be too detrimental for us, personally.

Are you not liberated?

Foreword

SPY is the first S&P500 ETF ever listed, and because of that first mover advantage, it has amassed a large number of shareholders. However, VOO, a competitor from Vanguard now beats SPY by net asset value, even though it launched much later. Should you switch?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Background

SPY is an ETF that tracks the S&P500 index, and so is VOO. In practice, the ETF providers have some leeway on how they actually implement the fund, but for the most part, they have a very high correlation and most people can treat them as effectively the same thing.

However, SPY has a 9bps (0.09%) expense ratio, while VOO has a 3bps (0.03%) expense ratio, making VOO slightly cheaper in terms of fees that users pay to own the shares ¹.

Because VOO has a lower expense ratio, and I believe it is one of the cheapest, if not the cheapest, S&P500 funds, it has drawn significant interest from many investors.

Expense ratio

You can think of the expense ratio as roughly “how much I pay per year to own this fund”. So for SPY, if you’ve bought $10,000 worth of SPY shares, then every year you will pay about $9 — this is done by the fund provider selling $9 worth of assets in the fund to cover your share of the fees. One way to think about it is, absent all other factors, the value of your holdings in the fund goes down by $9 per year.

Similarly, for VOO, you will pay about $3 per year if you had bought $10,000 worth of VOO shares.

So, if you bought VOO instead of SPY, you would save about $6 a year.

$6 isn’t a whole lot, but it’s not nothing. And given that there’s nothing you need to do, it seems like a no-brainer, right?

Liquidity

If it is a no-brainer, then why does SPY even have shareholders? Why don’t all investors just sell out of SPY and buy VOO instead? And why hasn’t the provider of SPY just lowered their fees to compete?

Well, the answer is that it is not that simple. It never is.

This is a screenshot from Interactive Brokers sometime this afternoon (Feb 21st, 2025) showing the prices of SPY vs VOO (edited to show the relevant bits):

As you can see, VOO has bid/ask prices of 557.68 vs 557.71, while SPY has bid/ask prices of 606.47 vs 606.48. As a simple model, let’s say the “correct” prices of a security is the midpoint price, i.e. the average of the bid and ask price. So for VOO, the “correct” price is 557.695, while for SPY it would be 606.475.

From the quotes, VOO trades with a spread (ask price – bid price) of 3 cents, while SPY trades with a spread of 1 cent. As a rough approximation, you can think of the spread as how much you pay (excluding broker and exchange fees) every time you buy and sell (i.e. one roundtrip) a share. So if you buy and immediately sold VOO, you’d pay 557.71 to buy, but only get back 557.68 when you sold, giving you a loss of 3 cents.

So, as a percentage of the “correct” price, the spread for VOO is about 0.5bps (0.00005%), while the spread for SPY is about 0.2bps. In other words, if you trade in and out of both SPY and VOO, you’d pay about 3x more for the trades due to the spread for VOO, than for SPY.

In concrete terms, if you buy $10,000 of SPY, you’ll pay in spread about 8 cents (0.01 * (10000 / 606.475) / 2), while for VOO, you’ll pay about 27 cents (0.03 * (10000 / 557.695) / 2). Note that divide by 2, because we are only buying and not selling, so we “pay” half the spread². Or, if you trade in and out of either position, you’ll pay 16 cents for SPY and 54 cents for VOO.

Given these numbers, if you trade in and out of your position 16 or more times a year, then it would make more sense to trade SPY than VOO — even if you hold the position everyday at the end of day, and thus pay the full $6 additional fee for holding SPY, you’ll more than make up for that by paying less in spreads when you trade — (54c – 16c) * 16 = $6.08.

If you don’t even hold the position at the end of every day, then trading SPY will come out further ahead, since you will pay a smaller fee to the provider (as a ratio of how many days you actually own the position out of the year).

16!

“But I’m a buy and hold investor”, you say, “I’m not going to trade in and out 16 times a year!”

And that is very true. Most people do not turn over their entire portfolio 16 times a year.

But that’s just one part of the liquidity story.

Here are some screenshots (again, edited for focus) of options expiring on March 21st, 2025 for SPY:

and VOO:

As you can see, an at the money call option for SPY trades at 9.17/9.20 bid/ask, while a similar at the money call option for VOO trades at 7.40/7.80 bid/ask.

As a percentage of the “correct” price per share, the SPY option has a spread cost of about 0.5bps, while the VOO option has a spread cost of about 7bps, an order of magnitude higher.

Which is to say, if you, like me, like to occasionally sell calls against, or buy puts to protect your S&P500 position, just buying 2 rounds of puts (or selling 2 rounds of calls) per year will result in SPY being a better vehicle for your portfolio — You’d pay roughly 6.5bps higher in spread costs to buy 2 rounds of puts (or sell 2 rounds of calls), if you let the options expire (i.e. you only pay the half the spread cost per trade), if you had used VOO instead of SPY (edit: for clarity).

While I don’t really trade that much, I almost definitely sell more than 2 rounds of calls per year on my holdings to juice my returns when I feel that the markets are especially richly valued, so for me, personally, trading SPY is usually a better idea.

Summary

While it is true that holding VOO is cheaper in terms of fees paid to the fund provider, be careful of all the other costs of investing. The 6bps you save per year by holding VOO instead of SPY is easily eroded if you trade options or the underlying even semi-frequently.

Of course, if you are a pure buy and hold investor who holds for the long term, then as of right now, VOO does indeed seem to be a no-brainer.

Footnotes

1. Users don’t actually get a bill or send money — the ETF provider just sells some of the assets of the fund to pay itself. ↩︎
2. Experienced traders will know that you can actually buy and sell closer to the midpoint than the spread, but that’s a story for another time. ↩︎

Foreword

Nowadays, many tech companies compensate their employees with restricted stock units (RSUs), effectively stock grants that vest over time. In most discussions with recruiters I’ve had, wonky maths was used to describe the actual compensation that is actually being offered, making comparisons between RSU-based and non-RSU based compensation packages difficult.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Restricted Stock Units

The typical RSU award works like this:

Let’s say your employer wants to pay you $100k over 4 years in RSUs. They will figure out a reference price of the stock at the time of the grant (i.e. when they decided to give you the award). Usually this is the price of the stock at market close on some particular day, or the average of the market closing price of some number of days.

Let’s say for our example the reference price is $100. In this case, you would be awarded with 1000 RSUs. The grant itself typically does not actually result in you getting shares. Instead, the grant is the promise of future shares. You only get the shares at set dates in the future, called vesting dates. For example, let’s say the shares vest once per quarter for the next 4 years. So each quarter, for the next 16 quarters, you’ll get 1000/16 = 62.5 shares each.

Vesting dates typically come with the stipulation that you remain employed with the employer — that is, if you quit (or are fired) before the full 16 quarters are up, you’ll forfeit any unvested shares of the grant.

To further complicate things, it’s common that a (large) part of your total compensation will come in the form of refresh grants, which are annual grants of new RSU awards, each of which are tied to a different reference price as well as award value (i.e. how much money your employer wants to actually give you). The employer may or may not disclose the reference price and/or award value, and may instead just choose to give you the total number of shares for each grant.

So, what you end up with, is a vesting schedule that looks something like this (assuming 1000 shares per grant, and consolidating all grants in the same year to shorten the table):

Year	Grant 1	Grant 2	Grant 3	Grant 4	Total
1	250				250
2	250	250			500
3	250	250	250		750
4	250	250	250	250	1000

After the 16th quarter, the first grant will be fully vested and you’ll stop getting shares from it. But the 5th grant will kick in, so you’ll continue getting 250 shares per quarter.

Note that typically the first grant is much larger than the refresher grants — this is because it is actually 2 grants in 1 — the first is the typical annual grant like a refresher grant, and the second is actually you sign on bonus. For simplicity, I’m ignoring the sign on bonus component for now, so all grants are more similar in size.

Presentation

When the RSUs award schedule is presented, recruiter will usually present the actual dollar amount of the shares you’ll get. Assuming that the shares start at $100 and increase by 10% per year, then the dollar amount of the vesting schedule looks like:

Year	Total shares vested	Dollar amount
1	250	$25,000
2	500	$55,000
3	750	$90,750
4	1000	$133,100

And from then on, the total value will increase by 10% a year (same number of shares, but share price increases 10% per year).

Now, if you want to estimate the value of your total RSU compensation in year 3, it is natural to think that it is $90,750. Did you notice the sleight of hand?

Sleight of Hand

There are 2 main issues with computing your actual RSU compensation:

• The increase in the share price confuses the matter
• You forfeit whatever shares are not vested in all grants if you leave the company

Now, given that, what do you think is the RSU based compensation for the 3rd year? Is it

• $90,750 — the actual value of RSUs received in year 3

OR

• $121,000 — the actual value of RSUs granted in year 3

?

The answer is… neither. It is actually $82,750, which is $25,000 (the value from the first grant) + $27,500 (the value from the second grant) + $30,250 (the value from the third grant).

Think of it this way — because you forfeit any shares not vested if you leave the company, at the time of the grant, you haven’t actually earned the award yet, so $121,000 is wrong.

At the same time, the first grant is worth only $25,000, despite you getting $30,250 from the 250 shares because that’s what the company intended to pay you when it made the grant — 250 shares at $100 each. The fact that the shares have gone up in value over the next 2 years is irrelevant — the additional 30,250 – 25,000 = $5,250 is the compensation you get for taking the risk of the stock exposure! Remember that instead of going up 10% a year, the stock price could just as easily have gone down instead.

Another way of thinking of it is this — if instead of giving you a 4 year deferred grant 1, the company had just given you the $100,000 flat out. In this case, you would have the choice of whether to buy the company’s stock or not. If you did, then you’d have bought 1000 shares (at a price of $100 per share). After the 4th year, your shares would then be worth $133,100. Would you now say that the first grant was $133,100 instead of $100,000? Obviously not!

If you had valued grant 1’s shares at the vesting price instead of the reference price, then you would value grant 1’s RSUs at a total of $25,000 + $27,500 + $30,250 + $33,275 = $116,025 over the 4 years, and that just doesn’t make sense — receiving the $100,000 upfront in year 1 is clearly better, since you get the money earlier, and you have the optionality of what to do with the money, so how can it be worth less than being forced to effectively buy your employer’s stock and to hold the stock for 4 years, while risk forfeiting part of the grant if you leave the employer early?

Taxes

One argument that some make for the RSUs instead of cash upfront, is that by deferring the payment, you are also deferring taxes, and since you are getting stock, you are benefiting from the deferred payment being invested, effectively compounding the part of the upfront payment that would have been paid in taxes.

Let’s model this out. Let’s say you pay long term capital gains taxes of 20% (highest) and marginal income taxes of 25% (somewhere in the middle).

In the RSU case, you would then receive:

Year	Vesting shares	Received shares	Total shares	Shares value (pretax)	Shares value (post tax)
1	250	187.5	187.5	$18,750	$18,750
2	500	375	562.5	$61,875	$61,500
3	750	562.5	1125	$136,125	$134,512.50
4	1000	750	1875	$249,562.5	$245,227.50

If instead you had been paid cash upfront, paid your taxes, and then bought the shares:

Year	Post tax grant	Total shares	Shares value (pretax)	Shares value (post tax)
1	$75,000	750	$75,000	$75,000
2	$82,500	1500	$165,000	$150,000
3	$90,750	2250	$272,250	$267,450
4	$99,825	3000	$399,300	$389,055

I think it should be clear in terms of cash flow, getting the cash upfront is better. However, if we just look at the first grant mathematically, in year 4, it will be worth:

• If received in RSUs, with 187.5 vested at 100, 187.5 vested at 110, 187.5 vested at 121, 187.5 vested at 133.10, for a total of 750 shares worth $99,825 pretax, or $97,263.75 post tax.
• If received in upfront cash, you’ll still end up with 750 shares, but worth $94,860 post tax, due to the lower cost basis of 100 for all shares.

So the main benefit of the deferral is that you have a higher cost basis for the shares received later, which does translate to a higher after tax dollar value if sold.

Whether this benefit is enough compensation for losing control/optionality of the grant for 4 years, and having to forfeit the unvested shares if you leave the employer early, is up to you.

Comparison shopping

When comparing compensation packages between an employer that pays with RSUs, vs another one that pays with cash, it is important to remember the RSU sleight of hand, and properly value what your compensation package will actually be.

The 3 key points to watch out for are:

• If you leave the employer, will the deferred part of the compensation still be paid?¹
• Properly value the dollar value of each grant by adjusting for the risk you are taking by being forced to effectively buy your employer’s stock.²
• The tax benefits of a higher cost basis for those shares that vest at a higher stock price than the reference price.

Footnotes

1. Some employers may have wording in the contract to the effect of “if you do something we do not like, and you get terminated for it, then the deferred part is forfeit”. In these cases, you’ll have to estimate for yourself how likely it is that you fall afoul of those rules. In many cases, the rules are actually pretty generous and you only forfeit the deferred payments if you break a law or otherwise get involved in some serious shenanigans.
   
   If you are confident the deferred payments will actually be made, then you should consider the payments to be made at time of grant (because that’s also when they vest). ↩︎
2. If the deferred portion is paid in cash, then you may need to discount the value of that cash to the time of vesting. ↩︎

Foreword

Everyone in finance seems to be chasing alpha, but very few people seem to really understand what it is. What is alpha, and why does it matter?

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Simply alpha

Alpha, in finance, specifically quantitative finance, is defined as the excess returns of a strategy above and beyond market returns. In other words, alpha measures the outperformance of a strategy — the higher the alpha, the better the strategy¹.

And because everything in finance is about *ahem* number measuring exercises, everyone in finance seems to be striving for higher alpha.

Unfortunately, many people, including those working in finance, don’t really understand what alpha is, and often conflate increased risk (which you do not want) with increased alpha (which you do want).

Maths

According to https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/alpha/, the mathematical formula for alpha is:

If you look at the equation more carefully, you’ll realize that:

• Alpha is net of the risk free rate.
• Alpha is independent of market return.

Which is to say, if all the return of a strategy can be expressed as a function of market return, then that strategy, by definition, has zero alpha.

To “simplify” things a bit, to compute the alpha of a strategy, run a correlation test of that strategy’s returns against SPX minus the risk-free rate (assuming you are using SPX as a benchmark), and the correlation, with magnitude, is your beta. (edit: clarified that beta is correlation + magnitude)

The part of the strategy’s return beyond that which can be explained by market returns (i.e. beta(R_m – R_f)) would be alpha + R_f, so you can compute alpha by just taking away from that remainder the risk-free rate.

Some examples

Now, let’s consider some examples:

• A fund that simply buys SPY, returning 33% in 2021, -14% in 2022 and 19% in 2023, with a cumulative total return over the 3 years of 34%.
• A fund that simply buys UPRO (3x SPY), returning 106% in 2021, -49% in 2022 and 43% in 2023, with a cumulative total return over the 3 years of 50%.
• A fund that returned 6% in 2021, 8% in 2022 and 9% in 2023, with a cumulative total return over the 3 years of 25%.

Clearly, the second fund has the highest cumulative total return, but which strategy has higher alpha?

Well, SPY is basically just the ETF expression of SPX, and UPRO is just 3x SPY, so the correlation of both funds would be very close to 1 (with SPY having a beta of around 1, and UPRO having a beta of around 3, edit: clarified that beta is correlation + magnitude), which implies both funds have zero alpha. However, the 3rd fund clearly does not move with the market — it goes up every year even when the SPX went down in 2022, and if you do the maths, it is returning about 5% above the risk-free rate every year. So the alpha of the 3rd fund is actually 5%.

Cue surprise

The above result often surprises many who don’t really understand what alpha means — how can a fund that returns less than SPY be considered to have alpha, while a fund that returned almost double of SPY has 0 alpha?

Recall that alpha is the part of the return that is above and beyond what can be explained by market returns. Both SPY and UPRO explicitly try to mimic market returns, with the exception that UPRO does it with 3x leverage. So neither have an excess return above that which can be explained by market returns, and the additional return UPRO provides over SPY is really just the result of UPRO taking more risk, in the form of using leverage.

Recall when we said people often confuse more risk (bad!) with more alpha (good!)? There you go.

The 3rd fund, on the other hand, has 0 beta², so all its returns are just alpha + R_f, and if you subtract the risk-free rate (generally assumed to be 10Y US Treasury yield), you get about 5% alpha per year.

But the returns suck!

Yes. Compared to both the first 2 funds, the return of the 3rd fund is indeed subpar. This is a common theme of true alpha funds — their returns tend to be around the 5-10% mark annually (edit: This is net of risk-free rate, i.e. alpha). Yes, there are some funds that have much higher alpha (e.g. the Medallion fund from Renaissance), but those tend to be closed off to outside investors.

The reason alpha funds tend to have lower returns, is because they are hard, and more often than not, they are rare. Alpha is hard because it is genuinely hard to find a strategy which will do well regardless of what the market does — most strategies have some non-trivial amount of beta associated with it just because they need to operate in the market. They are also rare, because most alpha strategies tend to have low capacity, meaning you can only put so much money into the strategy, before your positions affect the markets, and you distort the market enough that the returns dissipate.

Constructing an alpha only fund

To get some insights into a true alpha fund, consider a fund which returns 5% of alpha, and 80% of beta, i.e. the fund returns 80% of whatever SPX returns in any single year, and on top of that, returns 5% additionally (+ risk-free rate).

Well, we can convert such a fund into a true alpha fund by simply bundling this fund with a short up to 80% of your portfolio value of SPY. The total return of this bundle will now be: 5% + 80%SPY – 80%SPY = 5%, the alpha.

Not so fast though — shorting is not free. You typically pay a fee (short borrow fee, maybe margin costs, etc.) to short. To keep the maths simple, let’s say that the total fee for this shorting is 1% of total returns.

Which means, your true alpha fund, the bundle, will only return 4% alpha.

In general, a true alpha fund tends to involve a lot of trades to hedge out market exposure, which in turn will reduce the actual return (and thus alpha) of the fund.

Why bother?

So to recap, a true alpha fund first needs to find a good strategy, then pay fees to trade that strategy, and pay more fees to hedge out market exposure, just to get a net return of around 5-10% of alpha. While market return, at least in the past few years, has dramatically outperformed that with much less hassle.

So… why bother? Are Wall Streeters just stupid? Or maybe they just like Rube Goldberg-esque exercises in futility?

Let’s consider our 3rd fund again, which returned 5% alpha, i.e. 5% return net of risk-free rate.

Large institutional traders (and even savvy individual traders), can often get financing (i.e. loans) at, or close to, the risk-free rate.

If you are in such a position, then you can borrow, say $1m, at risk-free rate (R_f), then put that $1m into the fund to deliver a total return of alpha + R_f, which means effectively you get a return of alpha “for free”. Since this is a positive value arbitrage, you can simply re-lever your positions to get another loan at risk-free rate, put that new money into the fund to increase your returns. This process can be repeated forever — an infinite money glitch.

The ability to re-lever into positive alpha strategies, is also why these strategies tend to be rare — any existing alpha found will likely be pushed to its limits, until little, if any, alpha is left.

You can also lever into beta funds (i.e. buy UPRO), but that has limits — because market return can be negative, you cannot re-lever into the fund infinitely; There is a chance that a large enough negative year will wipe you out, so your lenders will likely place very strict and very conservative limits to how much leverage you can apply. After all, even if your strategy blows up, they still want to be paid!

Quickly identifying alpha

To conclude, if you are looking at a strategy, and you’re trying to figure out if the strategy has alpha, a simple way to quickly estimate this is just to look at the strategy’s total return over a period which includes a number of high return years and negative return years.

If any of these are true, then there’s a good chance that the strategy has positive alpha:

• The strategy manages to return more than the market in all of those years.
• The strategy has a fairly stable, positive return in all of those years.

But if the strategy simply returns more in good years, but also loses more in bad years, then even if the strategy’s total return over all the years is greater than the market, the fund may not have alpha, or may even have negative alpha.

Footnotes

1. A better and more complete definition can be found at https://corporatefinanceinstitute.com/resources/career-map/sell-side/capital-markets/alpha/. ↩︎
2. You can’t compute this based on the data provided, but let’s go with it. ↩︎