Archive for the ‘Investment’ category

Risk and Return – A Balancing Act

April 5, 2013

From Max Rudolph

There are similarities between value investing and enterprise risk management (ERM) methods. For some, especially portfolio managers, this may be obvious. These investors come to the table with experience using risk as a constraint while trying to optimize returns. Years of experience have taught this group that risk balances return, and that return balances risk. Value is added by creating favorable imbalances. The investor with high returns and average risk has succeeded, as has the investor reporting average returns and low risk.
Many concepts are shared between ERM and value investing. When defining risk, which is generally unique to the individual, an analyst considers uncertainty, downside risk, and optimization. Value investors look at concepts like conservative assumptions, margin of safety, and asset allocation. These concepts are comparable, and this paper uses the International Actuarial Association’s Note on enterprise risk management (ERM) for capital and solvency purposes in the insurance industry to take the reader through general ERM topics. This is followed by a comparable value investing discussion and a comparison of the two practice areas.

In some firms, a risk manager is placed in a position with little authority, limiting the benefits of ERM. A process driven ERM function can identify risks and risk owners, create a common language, and send useful reports to the Board. A stronger risk officer adds value by using transparency to understand risk interactions, scanning for emerging risks and generally keeping a focus on how an entity’s risk profile is evolving.

Continued in Value Investing and Enterprise Risk Management: Two Sides of the Same Coin

Very High cost for Asset Allocation Advice

May 10, 2012

Most investors in hedge funds must be looking at them totally marginally.  Certainly that is the way that hedge fund managers would suggest.

What that means is the ther investor should not look at the details of what the hedge fund is doing, it should only look at the returns.  Those returns should be looked upon as a unit.

Certainly that is the only way to think of it that matches up with the compensation for hedge fund managers.  They get paid their 2 and 20 based solely upon their performance.

But think for a moment about how an investor probably looks at the rest of their portfolio.  They look at the portfolio as a whole, across all asset classes.  The investor will often make their first investment decision regarding their asset allocation.

While hedge fund managers have argued for treating their funds as one or even several asset classes, they are almost always made up of investments, long and short, in other asset classes.  So if you are an investor who already has positions in many asset classes, the hedge fund is merely a series of moves to modify the investors asset mix.

So for example, if the hedge fund is a simple leveraged stock fund, the hedge fund manager is lowering the investor’s bond holdings and increasing the stock holdings.

So if an investor with a 70% 30% Stock bond mix changes their portfolio to 65%, 25%, 10% giving 10% to a hedge fund manager who varies runs a leveraged stock fund that varies from all cash to 4/3 leveraged position in stocks, then they have totally turned their asset mix over to the hedge fund manager.

When the hedge fund is fully levered in stocks then their portfolio is 65% long Stocks, 25% long bonds, plus 40% long stocks and 30% short bonds.  Their net position is 105% stocks with  5% short bonds.  But that is not quite right.  If you only get 80% of your performance, your position is 97% stocks and 1% bonds.  That is right, it is less than 100%.  Only it is really worse than that.  That is the allocation when performance is good.  When the stock market goes really poorly, you get the performance of the 105%/(5%) fund. 

Other funds go long and short large and small stocks.  The same sort of simple arithmetic applies there. 

It is really hard to imagine that anyone who thinks that there is any merit whatsoever to asset allocation would participate in this game.  Because they will no longer have any say in their asset allocation.  What you have done is to switch to being a market timer.  In the levered stock example, you now have a portfolio that is 65% long stocks and 35% market timing.  

So in most cases, what is really happening is that by investing in a hedge fund, the investor is largely abandoning most basic investment principles and shifting a major part of their portfolio asset allocation to a market timer. 

At a very large fee.

Prop Trading – Do Not Try This at Home

July 19, 2011

The GAO last week released a report on Proprietary Trading of banks. The headlines feature a conclusion from the report that the six largest US banks did not make any money our of Prop Trading over the 4.5 years of the study period.

The analysis looks pretty straightforward.  But it is difficult to see if the conclusions are quite so obvious.

First and most important for a risk manager to notice is that this is a post facto analysis of a risky decision.  Risk Managers should all know that such analysis is really tricky.  Results should be compared to expectations.  And expectations need to be robust enough to allow proper post facto analysis.  That means that expectations need to be of a probability distribution of possible results from the decision.

Most investments had performance that was vaguely similar to the pattern shown above during that time.  Is the conclusion really anything more than a 20-20 hindsight that they should have stayed in cash?  That is true everytime that there is a downturn.   Above is a graph of a steady long position in the S&P.

On the other hand, traders in such situations seem to generally get paid a significant portion of the upside and share in very little, if any of the downside.  In this case, the downside cancelled out all of the upside.  The good years had gains of over $15.6 B.  If the traders were getting the usual hedge fund 20% of the gains, then they were paid 3.9 B for their good work.  In the bad years, banks lost $15.8 B.  That means that the gains before bonus were $3.7B.  Incentives were over 100% of profits.

The one other question is why investors need banks aas intermediaries to do prop trading?  Why can’t investors do their own prop trading?  Why can’t investors go directly to the hedge funds or mutual funds or private equity funds?

Ultimately, the report says that prop trading was not really significant to bank earnings and not a real diversifier of bank volatility.  So in the end, is there any reason for banks to be doing prop trading?

It seems that the banks are reaching that conclusion and exiting the activity.

Another Fine Mess

May 9, 2010

High speed trading ran amok on Thursday, May 6.  It sounds like exactly the same thing that lead to the 1987 market crash.  There never was an explanation in 1987 and there most likely will not be one now.

Why not?  Because it is not in the interest of the people who are in a position to know the answer to tell anyone.

Look, the news says that this high speed trading is 75% of the volume of trading on the exchanges. That means that it is probably close to 75% of the exchanges revenue.

Most likely, the answer is that this sort of crash has always been possible at any time of any day with computers sending in orders by the thousands per minute. The people who programmed the computers just do not have enough imagination to anticipate the possibility that no one would want to take the other side of their trade.

Of course this is much less likely if someone actually looked at what was going on, but that would eliminate 90% of that volume.  Back before we handed all of the work to computers, the floor brokers who were the market makers would take care of these situations.

The exchange, that is benefiting from all of this volume, should perhaps be responsible to take some responsibility to maintain an orderly market.  Or else someone else should.  The problem is that there needs to be someone with deep pockets and the ability to discern the difference between a temporary lack of buyers or sellers and a real market route.

Oh, that was the definition of the old market makers – perhaps we eliminated that job too soon.  But people resented paying anything to those folks during the vast majority of the time when their services were not needed.

The problem most likely is that there is not a solution that will maintain the revenue to the exchanges.   Because if you brought back the market makers and then they got paid enough to make the very high risk that they were taking worth their while, that would cut into the margins of both the exchanges and the high speed traders.

Just one more practice that is beneficial to the financial sector but destructive to the economy.  After the 1929 crash, many regular people stayed out of the markets for almost 50 years.  It seems that every year, we are learning one more way that the deck is stacked against the common man.

In poker, when you sit down at the table, it is said that you should look around and determine who is the chump at the table.  If you cannot tell, then you are the chump.

As we learn about more and more of these practices that are employed in the financial markets to extract extra returns for someone, it seems more and more likely that those of us who are not involved in those activities are the chumps.

Are We “Due” for an Interest Rate Risk Episode?

November 11, 2009

In the last ten years, we have had major problems from Credit, Natural Catastrophes and Equities all at least twice.  Looking around at the risk exposures of insurers, it seems that we are due for a fall on Interest Rate Risk.

And things are very well positioned to make that a big time problem.  Interest rates have been generally very low for much of the past decade (in fact, most observers think that low interest rates have caused many of the other problems – perhaps not the nat cats).  This has challenged the minimum guaranteed rates of many insurance contracts.

Interest rate risk management has focused primarily around lobbying regulators to allow lower minimum guarantees.  Active ALM is practiced by many insurers, but by no means all.

Rates cannot get much lower.  The full impact of the historically low current risk free rates (are we still really using that term – can anyone really say that anything is risk free any longer?) has been shielded form some insurers by the historically high credit spreads.  As the economy recovers and credit spreads contract, the rates could go slightly lower for corporate credit.

But keeping rates from exploding as the economy comes back to health will be very difficult.  The sky high unemployment makes it difficult to predict that the monetary authorities will act to avoid overheating and the sharp rise of interest rates.

Calibration of ALM systems will be challenged if there is an interest rate spike.  Many Economic Capital models are calibrated to show a 2% rise in interest rates as a 1/200 event.  It seems highly likely that rates could rise 2% or 3% or 4% or more.  How well prepared will those firms be who have been doing diciplined ALM with a model that tops out at a 2% rise?  Or will the ALM actuaries be the next ones talking of a 25 standard deviation event?

Is there any way that we can justify calling the next interest rate spike a Black Swan?

Toward a New Theory of the Cost of Equity Capital

October 18, 2009

From David Merkel, Aleph Blog

I have never liked using MPT [Modern Portfolio Theory] for calculating the cost of equity capital for two reasons:

  • Beta is not a stable parameter; also, it does not measure risk well.
  • Company-specific risk is significant, and varies a great deal.  The effects on a company with a large amount of debt financing is significant.

What did they do in the old days?  They added a few percent on to where the company’s long debt traded, less for financially stable companies, more for those that took significant risks.  If less scientific, it was probably more accurate than MPT.  Science is often ill-applied to what may be an art.  Neoclassical economics is a beautiful shining edifice of mathematical complexity and practical uselessness.

I’ve also never been a fan of the Modigliani-Miller irrelevance theorems.  They are true in fair weather, but not in foul weather.  The costs of getting in financial stress are high, much less when a firm is teetering on the edge of insolvency.  The cost of financing assets goes up dramatically when a company needs financing in bad times.

But the fair weather use of the M-M theorems is still useful, in my opinion.  The cost of the combination of debt, equity and other instruments used to finance depends on the assets involved, and not the composition of the financing.  If one finances with equity only, the equityholders will demand less of a return, because the stock is less risky.  If there is a significant, but not prohibitively large slug of debt, the equity will be more risky, and will sell at a higher prospective return, or, a lower P/E or P/Free Cash Flow.

Securitization is another example of this.  I will use a securitization of commercial mortgages [CMBS], to serve as my example here.  There are often tranches rated AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, and junk-rated tranches, before ending with the residual tranche, which has the equity interest.

That is what the equity interest is – the party that gets the leftovers after all of the more senior capital interests get paid.  In many securitizations, that equity tranche is small, because the underlying assets are high quality.  The smaller the equity tranche, the greater percentage reward for success, and the greater possibility of a total wipeout if things go wrong.  That is the same calculus that lies behind highly levered corporations, and private equity.

All of this follows the contingent claims model that Merton posited regarding how debt should be priced, since the equityholders have the put option of giving the debtholders the firm if things go bad, but the equityholders have all of the upside if things go well.

So, using the M-M model, Merton’s model, and securitization, which are really all the same model, I can potentially develop estimates for where equities and debts should trade.  But for average investors, what does that mean?  How does that instruct us in how to value stock and bonds of the same company against each other?

There is a hierarchy of yields across the instruments that finance a corporation.  The driving rule should be that riskier instruments deserve higher yields.  Senior bonds trade with low yields, junior bonds at higher yields, and preferred stock at higher yields yet.  As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.

Thus, and application of contingent claims theory to the firm, much as Merton did it, should serve as a replacement for MPT in order to estimate the cost of capital for a firm, and for the equity itself.  Now, there are quantitative debt raters like Egan-Jones and the quantitative side of Moody’s – the part that bought KMV).  If they are not doing this already, this is another use for the model, to be able to consult with corporations over the cost of capital for a firm, and for the equity itself.  This can replace the use of beta in calculations of the cost of equity, and lead to a more sane measure of the weighted average cost of capital.

Values could then be used by private equity for a more accurate measurement of the cost of capital, and estimates of where a portfolio company could do and IPO.  The answer varies with the assets financed, and the degree of leverage already employed.  Beyond that, CFOs could use the data to see whether Wall Street was giving them fair financing options, and take advantage of finance when it is favorable.

Risks, Not Risk

October 9, 2009

From David Merkel in Aleph Blog

There is no generic risk.  There are many risks.  Are you getting fair compensation for the risks that you are taking?  If not, invest in other risks, or if there are few risks worth taking, invest in cash, TIPS, or foreign fixed income.

To this end, it is better to think in terms of risk factors rather than some generic formulation of risk.  Ask yourself, am I getting paid to bear this risk?  Look to the risks that offer the best compensation, and avoid those that offer little or negative compensation.

Modern Portfolio Theory has done everyone a gross disservice.  It is not as if we can predict the future, but the use of historical values for average returns, standard deviations, and correlations lead us astray.  These figures are not stable in the intermediate term.  The past is not prologue, and unlike what Sallie Krawcheck said in Barron’s, asset allocation is not a free lunch.  With so many people following strategic asset allocation, assets have separated into two groups, safe and risky.

Any risk reward strategy that is developed by looking backward at historical performance will no longer work well when everyone knows and uses it.  See the Law of Risk and Light Riskviews

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