Correlations, volatilities and expected returns as the monetary tide reverses flow..

I note comments by El-Erian over Central Bank’s inability to suppress volatility as a bigger risk than China and I would agree although I would qualify this in terms of the immediate asset price risk.   Asset focussed money supply growth and asset price relatives (relative to GDP growth and income growth as well as its distribution) are all deeply negative for asset markets when liquidity dynamics, amongst others, change.

Recent commentary by Zero Hedge on the winding up of Nevsky Capital is also worth reading: the Nevsky Capital report suggested that a disciplined structure can no longer be counted on to realistically manage risk and return given the uncertainty of an increasingly skewed distribution of possible outcomes in an environment worryingly distanced from fundamentals/exposed to unconventional monetary policy; liquidity dynamics in the market place also impacted.  

Another interesting piece of data shows the 10 year rolling returns on commodities that I found in a tweet from @zatapatique.

I have written on the issues of excess asset focused money supply and liquidity for some time (relevant posts of mine).

Many portfolio management structures depend on expected return/correlation/standard deviation assumptions that would be very much exposed to a break in the direction of money flows towards assets.  All statistical measures of risk and co variance are drawn from the impact of monetary demand flows for assets.  In an environment where monetary policy is accentuating flows to asset classes as well as expanding the quantity of money and reducing the supply of certain asset classes the natural flow response to risk and return in the environment are muted.  As unconventional monetary policy recedes, additions to the quantity of asset focussed money and interest rate support reverses, the natural flows not only start to reassert but the prior excess flows adjust to the new environment.  We get a break out of trading ranges and covariances.

This is all incredibly risk and uncertain for those dependent on traditional statistical measures of asset price sensitivities and covariances.

Fama on tapering–it all depends on your view of the Fed and the market.

Just watched a short clip on Zero Hedge with Ric Santelli and Eugene Fama discussing tapering.  Fama said that tapering would be a neutral event.

Fama’s point was that tapering is a simple balance sheet exercise whereby the Fed transfers the securities it has bought for the short term debt (deposits) it has issued.  I guess in a sense, if it is a neutral exercise, the impact would be determined by the interest rate differential on the two.  But it could be a lot more than this.

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The lost world of asset allocation Part 3: Risk Premium Differentials and Liability Frames.

One of the most important determinants of asset allocation is the risk premium on risky investments. 

The lower the risk premium on risky assets the less rationale there is for their inclusion and the longer the time frame of “risky asset risk” that a portfolio will need to manage.  Asset allocation decisions that involve allocating to longer term higher risk growth assets to provide the differential expenditure (income and capital liabilities less portfolio dividend, interest and other income) are about capturing differences in risk premiums.

But this also requires that asset allocation is also framed in terms of units of liabilities as opposed to just units of assets, such that risk management uses size and timing of liabilities as the primary determinant of rebalancing transactions and asset allocation decisions.   The time frame of risk for risky assets is framed likewise in liabilities.

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What is investment risk?

“What is investment risk” is both simple and complex and in order to assess the information needed to assess risk we first of all need to qualify the world view of risk and return and then the model we are using to manage the risks and their impact. All this is beyond the subject matter expertise of the individual investor and why point of sale documentation can only ever inform about the broad nature of risk and return but never be sufficient to allow the investor to fully own the decision. Ownership of the transaction decision resides with ownership of the process and the significance of risk assumed with respect to risk via structure, assumptions and costs.

At a very basic level, risk is what happens to a price between two points in time and the impact of that movement in price – it can be both positive and negative.  But what gives rise to risk is more important than a mere list of risk factors, or indeed a narrow quantitative measure of risk.

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Standard deviation may not tell the whole story but it does tell a story

In terms of risk, a prior positive demand flow (+ve standard deviation) has more impact on liability risk in an out of equilibrium world, so that arguments that suggest that a statistic that fails to focus only on the downside is meaningless are incorrect.

Way back when the world was more enamoured than today about standard deviation I openly discussed its weakness in terms of managing liability risks.  This was primarily to do with the fact that mean variance optimisers did not incorporate liabilities into the portfolio construction (optimisation process) and ignored relative and absolute valuation issues. 

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Long run predictability of asset prices..

Robert Shiller and Eugene Fama were two of three academics who won the Nobel Prize for economics for different accounts of asset price predictability: the former regarding its bounded long term predictability and the latter regarding its short term unpredictability.

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Asset allocation in a financial crisis..

Portfolios with liability demands need to be run along liability tracks with a greater sensitivity towards a) liability risks in terms of benchmark allocations to risky assets and allowed for deviations from those benchmarks and b) cyclical market and economic risks and especially significant structural risks that could materially impact returns on risky assets.  

It is more what portfolios do in terms of adjusting allocations given liabilities profiles as risky asset prices inflate, than what portfolios can and cannot do in a risk event when asset price declines have pre-empted any possible move.

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Risk and Return Within the Stock Market: What Works Best?

From Risk and Return Within the Stock Market: What Works Best? By Roger G. Ibbotson, Ph.D. and Daniel Y.-J. Kim, Ph.D:

Contrary to theory, low beta and low volatility portfolios outperform high beta and high volatility portfolios……. Overall the best returning characteristics are high earning/price, high book to market, and low turnover. On risk adjusted basis, the best performances were low beta, low volatility, and low turnover……Within this anomaly, a common theme emerges. Whether it be through factors that encode popularity among investors (turnover, growth), academic popularity (citations), or popularity caused by leverage aversion (beta, volatility), popularity underperforms.

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When beta is wrong…and by implication expected return, risk and covariance..

One of my many issues with modern portfolio theory is that it assumes not only that markets clear but that supply and demand are also optimal.

In a low growth environment where asset prices are being pushed upwards through quantitative easing, modern portfolio theory tenets becoming increasingly irrelevant for efficient asset allocation in risk return space and a serious risk to effective withdrawal management.  In such an environment we have to be very careful in our assessment of beta and the risks both allocating to and away from it present.  

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Could the optimal portfolio structure please stand up!

Part of the lure of modern portfolio theory is that it provides a theoretical basis for a correct asset allocation to all assets.  If we knew the expected return of bonds, equities and other assets, and we knew how their prices would move in relation to each other over time, and all these price movements were random, independent and uncertain, the MPT model would be the perfect model.   For those who wanted to increase risk or reduce risk, just reduce the allocation to the market portfolio or leverage up.   Everyone needs an allocation benchmark!   Such a structure, assuming the satisfaction of the assumptions, would be optimal even for those drawing down on capital.

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We cannot change what is… but we can certainly plan for much of what is….

Markets react daily to news, but most of the news, in truth, is already baked into the pie.

Daily data points can easily move in ways that are at odds with the overall direction of underlying fundamentals, and, of course, everyone interprets that information differently.  Many minds have differing agendas and it is quite often the agenda that defines a data point’s interpretation.  Much of risk is therefore driven by irrationality and agenda, and even rationale exploitation of irrational acts.

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MPT and the Fiduciary Wars – Part 3

This post deals with arguments against MPT from the legal side of the debate, in particular with respect to Fiduciary responsibility. 

As discussed in previous posts, the issue of Fiduciary responsibility is being pushed to the fore in retail financial services and the issue of what is and what is not prudent investment practise to satisfy fiduciary type obligations is important.  My viewpoint for the last 2 decades has been that MPT ignores key market risks and that these key market risks do need to be managed. 

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Some interesting snippets from the report:

Regulatory authorities at EU and domestic level should apply fiduciary standards to all relationships in the investment chain which involve discretion over the investments of others, or advice on investment decisions. These obligations should be independent of the classification of the client, and should not be capable of being contractually overridden

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“It’s time to reset your investment assumptions”..says the Globe and Mail. But is it, and should it be up or down?

Is it really time to reset your return assumptions downwards? A Rob Carrick articlein the Globe and Mail suggested that it might be so.

Revising return assumptions down after poor stock market returns is a Bete Noire of the financial services industry.  All other things being equal, and depending on your paradigm, you should be revising them up after a period of poor returns.

But you cannot revise upwards if your return assumptions were too high to start with. If you have relied on historical average returns or risk premiums to set return expectations you have also more than likely failed to adjust for cyclical and structural risks in markets and economies. Continue reading

From the Certainty of Efficient Markets has come Moral Hazard!

In my previous post I picked up on a statement in a Dan Solin article.  My concern was that the article appeared to express a level of certainty regarding an investment outcome that to me reflected the type of moral hazard that has, in my opinion, negatively impacted the world financial and economic system, in particular, since the latter half of the 1990s.  This is not to say that moral hazard has not always been a feature of human decision making, just that I believe MPT helped legitimise it. Continue reading

Dan Solin’s “A Rational Response to Irrational Market Anxiety”

There is much on which I agree with Dan Solin: I agree that index funds, as a way of accessing an asset allocation component within the market, are very efficient and effective, and that it is impossible for everyone to try and beat/time the market, consistently, at any one point in time.   Most people, most of the time, are better off with the index and doing nothing!

I also agree that you are best off ignoring the papers and the hype, but I disagree that you should ignore issues relevant to valuation, and this is essentially where we part company. Continue reading

Standard deviation as a risk measure and the false reality of modern portfolio theory..

I have meant for some time to pen some further thoughts,held for a long time, on the modern portfolio theory paradigm.  My reply to a recent e-mail provoked a brief encapsulation of these thoughts.  My brief e-mail reply is noted below, and below this a more detailed description of the position.

If markets are efficient, and in a general equilibrium, then historical standard deviation will provide you with an “average” sensitivity of price movements to an average set of new information/events/shocks.  

The actual price movement at a point in time should have a direct relationship to the news event/shock, and the price movement should therefore be predictable for a given shock.  What the average standard deviation does not do is provide you with, in your face as it were, the price movement for all events, both big and small.  This is found in the distribution, and for a given equilibrium, the distribution of returns only represents the dataset for one run, or one string of outcomes, for that equilibrium.   It tells you nothing about the future shocks, just how price reacts to a shock.  

In other words, the standard deviation does not provide the investor, unless they are mathematically inclined, with a full distribution of the price movements of their investment, nor does an historical analysis of price movements provide you with the future profile of price movements.   As stated, it only tells you the qualities of the elastic band, nothing about the forces that will attempt to shape it.

But, once we are out of equilibrium then all the physical qualities (normal distribution) of a risk measurement based on standard deviation go out of the window.    Way out of equilibrium you only need a small shock to cause a large price movement, so the relationship between risk and change is lost.  Standard deviation becomes meaningless.  An analogy, is that an elastic band that is fatigued has different physical properties to a new elastic band: we have a fatigued elastic band and standard deviation only applies to new ones.

I think it worth revisiting some of the dogmas that gave the green light to mankind to go forth and multiply to go forth and leverage him/herself to death, spreading his/her seed risk  amongst those whose collapse would strike at the heart of our universe who could best bear it.   The world was not becoming a safer place at all, but a riskier, far more dangerous and leveraged place.

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Most people are so far out of their depth in this crisis one wonders whether this is more than just a failure of the financial system!

The bund that broke the Bundesbank is a post at FT’s Alphaville that offers one explanation for the apparently poor German bund auction today.  It states that the reason for the poor auction was the need for the Bundesbank to retain an increasing share of bonds at auction to suppress interest rates in the German repo market. 

The rate is important to suppress because almost all interbank funding is now done on a secured basis against the best quality collateral. Which implies two important points: 1) that the ECB itself has lost control and depends almost entirely on the Bundesbank to enforce its low rate policy target and 2) that the Bundesbank is having to retain more bunds from the market than ever before just to ensure the last functioning repo rate in Europe doesn’t spiral out of control.”

One of the important things about this crisis is the ever increasing amount of detail that is being delivered.   This type of detail would in normal times be far removed from most analysis, yet, in order to understand what is actually happening and to make sense of it, the financial community is having to dig deeper and deeper.  

The truth of the matter is that the world had started to become a much more complicated place towards the latter part of the 1990s and that simple rules of thumb, valuation and asset allocation benchmarks had ceased to have relevance to the increasing risks in the financial and economic universe. 

I had expressed these very same concerns during 1996 and 1997, when I was running money and developing systems.  Yet, from this point on, it only seemed to get worse with the investment world all to ready to accept simple mantras, systems and solutions for the management of money.  

One of my main themes is that we are taught to understand and deliver the solution, often without question.  Beneath the solution lies the theory and beneath the theory lies the problem.  Few venture beyond the need to understand the solution and fewer still go deep into the problem to question the theory upon which our financial edifices are built.  This is one of the reasons why we are in this mess: not just the central banks, the governments, the crooked banksters, but an educational system that rewards the correct, but not necessarily the right answer. 

What is the worth of an an educational system when there is only one predetermined “correct” answer and any attempt to think outside of the box is not rewarded? 

When we oversimplify we find not only that the world becomes too complex for us to manage, but that our model of what is, no longer represents reality!