Thursday, August 30, 2007

Fair use

Copyright law and the doctrine of "fair use" has become a hot topic in today's digital, interconnected world. Copyright holders have been flexing their muscle as they try to contain the unauthorized distribution of their work (not always successfully; see my earlier post on DRM). The rights of copyright holders is subject to certain limitations. An important limitation is codified in the doctrine of fair use. Section 107 of the Copyright Act says:

...the fair use of a copyrighted work ... for purposes such as criticism, comment, news reporting, teaching (including multiple copies for classroom use), scholarship, or research, is not an infringement of copyright.

Unfortunately, the difference between "fair use" and infringement is not always clear. Today something quite interesting happened in the world of copyright and fair use. Chris Knight writes about a video he posted on YouTube. Viacom claimed copyright over this video and sent YouTube a "take down" notice. YouTube obliged and sent Mr. Knight a notice saying that the video was being taken down. The only problem was that the video in question, produced by Viacom subsidiary VH1, was produced---without permission---from a video originally made by Mr. Knight! Mr. Knight is most aggrieved:

Viacom used my video without permission on their commercial television show, and now says that I am infringing on THEIR copyright for showing the clip of the work that Viacom made in violation of my own copyright!

I wonder which of these uses would be considered "fair use". Mr. Knight raises another interesting question:

What does this mean for independent producers of content, if material they create can be co-opted by a giant corporation without permission or apology or compensation? When in fact, said corporations can take punitive action against you for using material that you created on your own?

I wonder what the Electronic Frontier Foundation (EFF) would have to say about this.

Thursday, August 23, 2007

Rising Above the Gathering Storm

Much has been written about the advantages and challenges of globalization and out-sourcing. I was first introduced to the issues in Tom Friedman's fine book The Lexus and the Olive Tree. Specifically, I was introduced to the phrase "creative destruction" coined by economist Joseph Schumpeter:

Schumpeter, a former Austrian Minister of Finance and Harvard Business School professor, expressed the view in his classic work Capitalism, Socialism and Democracy that the essence of capitalism is the process of "creative destruction"---the perpetual cycle of destroying the old and less efficient product or service and replacing it with new, more efficient ones.

The essential point is that:

Those countries that are most willing to let capitalism quickly destroy inefficient companies, so that money can be freed up and directed to more innovative ones, will thrive in the era of globalization.

Historically, the US has been very good at destroying inefficient companies and directing capital toward more innovative ones. Which brings us to the current situation. Outsourcing of technology jobs and various business processes is well underway. That's the "destruction" part. But where's the "creative" part? What's going to be the next big thing that will create massive employment in the US? And what can the US do to ensure that this happens?

Congress asked the National Academies these very questions. In response, the National Academies put out a comprehensive report entitled Rising Above the Gathering Storm (the Executive Summary of this report is worth reading). In this report, they take as their starting point Tom Friedman's assertion in The World is Flat that:

...the international economic playing field is now "more level" than it has ever been.

and that

...whether global flatness is good for a particular country depends on whether that country is prepared to compete on the global playing field...

The National Academies identified two key challenges for the US: creating high quality jobs and responding to the nation's need for clean, affordable, and reliable energy. They propose four high-level recommendations and twenty specific implementation steps to address these challenges. The four recommendations are:

  • 10,000 teachers, 10 million minds and K-12 science and math education.
    The idea is to increase the talent pool by vastly improving K-12 science and math education.

  • Sowing the seeds through science and engineering research.
    The idea is to sustain and strengthen the traditional commitment to long-term basic research that has been the engine of innovation.

  • Best and brightest in science and engineering higher education.
    The idea is to make the US the most attractive place to study and perform research so that it can attract and retain the best students from within the US and around the world.

  • Incentives for innovation.
    The idea is for government to take actions to modernize the patent system, to enact tax policies that encourage innovation, and to ensure affordable broadband access.

Congress and the President seem to have taken these recommendations seriously. As noted in an op-ed by two authors of the above report, earlier this month the 21st Century Competitiveness Act was signed into law with strong bipartisan support. This law substantially increases the basic research and development budgets of key federal agencies (like NSF, NIST, and DoE's Office of Science), and authorizes $43 billion for STEM education: science, technology, engineering and math. Thus, it appears to follow the first two recommendations.

There is, however, a catch. The authors of the op-ed end with:

We are under no illusions. What is authorized by this act is not necessarily what will get funded. If the appropriations committees fail to follow through, the country will lose the opportunity to take a page from its own playbook of 50 years ago and assure American leadership in the world of technology and innovation.

Hopefully the appropriations committees will follow through.

Saturday, August 18, 2007

Exchange Traded Funds

Do you have a largish sum of money that you need to invest wisely? Maybe your start-up just got acquired or (better still) went public. Or maybe you just reached the 1 year cliff on your options vesting. Or maybe you switched jobs and you've rolled over your 401k into an IRA at a brokerage firm. Or maybe you inherited some money from a rich uncle.

Whatever the source of the money, are you now faced with the problem of how to invest it wisely? Maybe you've decided against picking your own stocks because you're concerned about risking your nest-egg on a high-flier like AAPL (betting that the iPhone will take Apple to new heights...) or on a beaten down stock like PALM (thinking that it's undervalued because the Treo will make a dramatic comeback...). And maybe you're concerned that paying a financial advisor 0.5%-1.0% of your assets annually is too high a cost for unclear benefits. Maybe you want to invest in mutual funds, but you're not sure which ones to invest in.

Well I have a suggestion for you: invest in a portfolio of Exchange Traded Funds (ETFs). Seeking Alpha has a really great and comprehensive guide to ETFs. But before you read that guide, here's a short summary of the highlights. I'll try and explain what they are, why they're good, when you should avoid them, and a sample portfolio that we use. (Caveat: I'm not a financial advisor. Nor do I have any formal investment background. So you should take everything in this post as my personal opinion only.)

What are ETFs

ETFs are like index mutual funds in that shares in an ETF represent ownership in an underlying basket of securities that track some index (e.g., the S&P 500 index). However, unlike a mutual fund, small retail investors cannot buy (sell) shares directly from (to) the Fund company. Rather, such investors can trade ETF shares with other investors on a stock exchange. One consequence of this is that ETF shares can be traded throughout the day, rather than just at the end of the day like mutual funds.

How do ETFs work

A second consequence of trading ETF shares on a stock exchange is that shares can trade at a premium or a discount to the net asset value (NAV) of the underlying securities. However, as a practical matter, ETF shares trade at prices close to the NAV. Here's why. ETF shares can be exchanged with the Fund company for a basket of the underlying securities. These in-kind exchanges are allowed only for bundles of a large number of shares, typically 100,000 shares. This means that the only entities likely to make such exchanges are large institutions.

So now imagine that ETF shares are trading at a premium to NAV on the stock exchange. A large institution, wanting to profit from this premium, will give the Fund company a basket of securities representing the index (priced at the NAV) and get an equivalent number of ETF shares (priced at the premium). They can now profit by selling these ETF shares on the stock market. But by selling these ETF shares, they drive down the price of the ETF toward the NAV.

The opposite happens if ETF shares are trading at a discount to NAV. The large institution will buy ETF shares (priced at the discount) on the stock market and return them to the Fund company, getting back the basket of securities (priced at the NAV), thus making a profit. But by buying these ETF shares, they drive the price of the ETF up toward the NAV.

The net effect of all of this is that the price of an ETF usually stays very close to the NAV.


With mutual funds, when other investors redeem shares, the Fund may have to liquidate some of the underlying securities to fund the redemption. This can generate capital gains, which are shared proportionally by all investors in the Fund. Thus you can incur capital gains when someone else redeems shares.

This doesn't happen with ETFs. Since all exchanges with the Fund are in-kind, the Fund incurs no capital gains as a result of exchanges. When retail investors sell ETF shares, there's no change in the Fund's holdings of the underlying securities. So, once again, the Fund incurs no capital gains. Thus, investors in the fund incur no capital gains when others sell or exchange shares.

The only way fund investors incur capital gains is if the underlying index changes (so the Fund has to sell some securities and buy others to come in line with the index), or if investors themselves sell ETF shares. As with mutual funds, investors get their proportional share of interest and/or dividends thrown off by the underlying securities.


Since ETFs are essentially index funds, one of their big advantages is low costs. A typical ETF following a major index may have costs under 0.2%. This is in contrast to an actively managed stock mutual fund that may have costs in excess of 1.0%.
(Note that there has been a proliferation of specialized ETFs following sectors or small sections of the market and these might have higher costs.) ETF costs are usually deducted directly from the interest and dividends thrown off by the underlying securities.

One cautionary note on ETF costs: since ETF shares are traded on the stock exchange, they do incur trading costs. Thus, to keep these trading costs low, you need to trade a significant amount. For example, suppose that your discount broker offers trades at $10 per trade. If you now buy ETF shares worth $1,000, then the trading costs are 1.0%. That really works against the low cost advantage of ETFs. To keep the low cost advantage, you'll need to trade larger amounts, e.g., at least $5,000 for a 0.2% cost. The main consequence of this limitation is that ETFs are not a good vehicle for dollar cost averaging over a period of time by, say, investing $500 per month. This is the reason for the introduction to this post where I talk about having a largish sum to invest.

ETF Portfolios

By now you're probably thinking, "Okay, okay, you've convinced me that ETFs are great. But which ones should I invest in?" The ETF guide I linked to above suggests a core portfolio consisting of 10 funds and a low-maintenance portfolio consisting of only 5 funds.

We've been using a different portfolio consisting of 13 funds. It is one of the portfolios originally recommended by Burton Malkiel, professor of Economics at Princeton and author of the classic investment book A Random Walk Down Wall Street. I heard a talk by Malkiel about 2 years ago in which he extolled the virtues of ETFs and suggested four different ETF portfolios for different levels of risk. You can find these four portfolios here. (Caveat: These were recommended 2 years ago, and there's no reason to believe Malkiel hasn't changed his recommendations since then.)

I don't want to imply that these portfolios are the best available. But I will say that you could do a lot worse by following some active management strategy (unless you really know what you're doing). Following one of these portfolios allows you the comfort of knowing that you're going to do pretty well, probably better than a majority of investors, with almost no effort at all. And no stress either: whether the stock market is up or down, your investment strategy doesn't change.

One other thing that Malkiel mentioned is to rebalance the portfolio once a year. The idea is some ETFs may do much better than others and may grow to take on a disproportionate share of your portfolio. You then sell some of that fund and buy funds that haven't performed as well. Of course, you need to do this carefully because rebalancing always incurs costs.

Tuesday, August 14, 2007

Perseid meteor shower

Last Sunday we went out to watch the Perseid meteor shower. This meteor shower occurs because the Earth passes through the debris left behind by the comet Swift-Tuttle. The particles in the debris are very small, ranging from grains of sand to small pebbles. (Someone described them to be similar to the contents of a box of Grape-Nuts.) These particles travel through the Earth's atmosphere at speeds of up to 130,000 mph and instantly burn up and produce beautiful shooting stars in the sky.

Sunday night was the peak of this year's Perseids. We went to bed early and woke up at midnight. We joined a friend and her kids (so we were 3 adults and 4 kids in our party) and drove up Page Mill Road to the parking lot of the Monte Bello Open Space Preserve. I picked this location because it is relatively close and because it seems many amateur astronomers use it for star gazing parties. It turned out to be a pretty good location: it was very dark and while there was some light pollution from Bay Area lights, it wasn't too bad and mostly affected the eastern horizon. Once our eyes dark adapted, you could see the Milky Way overhead (though it wasn't as clear as the view I had from the remote rural location of the village of Bordi in Gujarat, India).

And then we started seeing meteors! They were great. They'd flash by in different parts of the sky at an enormous pace: before you could react they were gone. Not that it stopped us from reacting---we were with kids and they would excitedly yell out "There's one!" each time they saw a meteor. But, of course, if you missed it, there was no point looking to where they were pointing. We were probably the noisiest group there with their regular squeals of joy! The newspaper had suggested that one should go meteor watching with someone with whom you'd enjoy sitting in the dark. This is certainly good advice, but I'd add that it's even more fun to go with excited kids!

Each of us saw roughly a dozen meteors (some saw more, some less). But, of course, not everyone saw the same meteors, so there were at least two dozen meteors in the 30-45 minutes that we were there. That means meteors were showing up at the rate of about one every two minutes or so. It was lots of fun! If you've never seen a meteor shower, I highly recommend it. You can find information about other meteor showers here.

Friday, August 10, 2007

Carbon taxes and cap-and-trade

Global warming has become one of the key issues in this presidential election cycle. Various proposals have been floated to combat it, including alternate energy sources, carbon taxes, cap-and-trade policies. Greg Mankiw, Professor of Economics at Harvard and the Chairman of the President's Council of Economic Advisers from 2003 to 2005, is a strong advocate of a $1 per gallon gas tax. (Such a gas tax is a Pigovian tax levied " correct the negative externalities of a market activity.") Back in Oct, 2006, he wrote a manifesto for such a Pigovian tax for the Wall Street Journal (reprinted in his blog). He makes quite a compelling case, though he ends by recognizing the political hurdles in passing such a tax:

But don't expect those vying for office to come around until the American people recognize that while higher gas taxes are unattractive, the alternatives are even worse.

Interestingly, it seems that Barack Obama may be considering something that may be equivalent to this Pigovian tax. In a recent blog post, Mankiw points to an interview with Obama in which Obama says that he prefers a cap-and-trade system in which permits are auctioned of rather than being freely given away. Obama says that: I roll out my proposals for a cap-and-trade system, I will price permits so that it has much of the same effect as a carbon tax.

I don't understand the cap-and-trade system or what it means to auction off permits. But the idea of using auctions seems like a good way to price things (cf. Google's auction for keyword ads). And if it has the effect of a carbon tax, but is more palatable because it's more market-driven, then this sounds like a good thing.

Tuesday, August 7, 2007

Where were you for 756*?

While I'm not a big baseball fan, I've been following Barry Bonds's chase of the home run record with great interest. As luck would have it, I dropped off some friends at the airport this evening and as I started the drive home I turned on the radio to see what was happening. And what do you know: Bonds was up next for his third at-bat after having hit a double and a single in his first two at-bats! The crowd was electric, chanting "Barry! Barry!" Once Bonds got in, the count quickly reached three and two. And then Bonds got a fastball. And he launched it 435 feet for his record breaking 756th home run...! The crowd went absolutely crazy! All very exciting!

What followed was a lesson in taking the high road. With the steroid controversy engulfing Bonds, Hank Aaron had previously refused to attend Barry's record breaking run. But when Barry came out on the field with Willie Mays, Aaron appeared on the big stadium screen and very graciously congratulated Barry on his singular achievement:

It is a great accomplishment which required skill, longevity and determination. Throughout the past century, the home run has held a special place in baseball and I have been privileged to hold this record for 33 of those years. I move over now and offer my best wishes to Barry and his family on this historic achievement. My hope today, as it was on that April evening in 1974, is that the achievement of this record will inspire others to chase their own dreams.

Now that's classy. Quite unlike Bud Selig's classless performance in San Diego when Bonds hit 755.
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