Tuesday, February 15, 2011

Deutsche Bank on MVP Investing

DB has a new white paper on Minimum Variance Portfolios (MVPs), and finds they outperform the indices (see above). In their case, they don't go long the lowest volatility stocks, but rather form a long-short portfolio They then make a long-short Minimum Variance Portfolio, and show it dominates the indexes (see above). As they say:

all else equal, the MVP aligns the portfolio in reverse to stock beta. More importantly, the MVP which is supposed to be agnostic to expected stock returns has revealed itself as a strategy that, all else equal, makes the implicit forecast that stocks with higher beta will underperform stocks with lower beta. This, of course, flies completely in the face of traditional asset pricing theory. If we believe CAPM and think of beta as a proxy for a stock’s expected return then any of the characterizations in (3)-(5) imply that the MVP strategy is forming a portfolio in reverse direction of the expected return forecasts!

Idiots overpaying for lottery tickets and underpricing boring equities. You won't hear much about low volatility companies on CNBC, or in your spam folder, because they are so unsexy, which is why they are underpriced.

The following is from my book on stock recommendations, where I note that in contrast to standard asset pricing theory, ALL stock recommendations promise above average returns. In theory, half of all stocks should be recommended with below-average returns because they have good 'risk adjusted' returns. That this never happens highlights the theory is seriously wrong. People only take risk to outperform, never to achieve a lower return with greater safety (excluding cash-like asset holdings, such as AAA bonds or short term paper). More videos are here.

Anyway, a major problem with quants is what Shakespeare called 'guilding the lily': they take something good, and make it worse by trying to make it better. In the case of the pervese cross sectional results we see: lower return for high vol stocks, higher returns for low vol stocks. As usual, they begin by noting they do not overfit the problem, in the same way someone says 'while I'm fiscally conservative...', and then decide to load up on the short weighting of really high risk companies by setting all their 'residual risks' to be the same. They find this increases the return but does not affect the portfolio risk so much: the magic of diversification!

Shorting highly volatile stocks is a crappy strategy because while it has a positive return (ie, the high fliers lose money in a long-only sense), the volatility is very high. You simply would have been destroyed in 2009, or 1998-99. Plus, shorting a portfolio is simply very difficult for noninstitutional investors, something they do not have a comparative advantage at relative to the institutional investors like hedge funds, and a good relation with a short desk. If you aren't getting equal access, don't do it, because in asset markets the second tier gets severely adversely selected, and you will pay too much, and get 'bought in' at the worst times.

1 comment:

Anonymous said...

What do you think about how "private equity" firms make money? Some have suggested that the basic strategy is to buy relatively safe companies, load them up with debt, and then re-sell them to the public in a riskier state (with the added risk not being penalized by the market). As a bonus, creditors get screwed by the extra riskiness unless they have negotiated strong protection.