I went to a wealth conference for high net worth individuals, because I knew one of the brokers (I'm not a high net worth individual). This firm is a global brand with $540B or so under management. He spoke in very simple terms, as if these people knew about as much about markets as your average person who reads the paper. The lead speaker tried to explain their Dynamic Asset Allocation strategy, that purported to lower risk. It did this by basically emulating a put option, also known as Portfolio Insurance, reducing equity exposure in draw downs (Leland and O'Brian and Rubinstein famously did this with a lot of money, exacerbating the the 1987 stock-market crash). It's not a bad tactic, but seems rather fragile, as such a rule clearly would have helped in 2008 as the increase in volatility occurred prior to the big drawdown in the second half of 2008, but other than that the time series data generally shows that such a rule merely lowers one's return.
But I was most interested that the practitioner insisted this lowered volatility, specifically drawdowns, and did not lower returns. It seems that lower risk is only tolerable if it doesn't hurt returns, because they were very clear about this.
Another interesting point was that changing equity or currency exposure was mainly done via overlaying with a hedge, as opposed to exiting positions, because this had lower tax implications. This highlights that having different taxes on assets based on how long they are held, or whether the return is dividends, capital gains, or interest, just increases financial complexity. The more the government tries to favor the kind of investment they like, or more likely increase taxes on areas with less political support, creates more derivatives, more trades, and only helps the middleman. If one really hates how much the average Goldman Sachs employee makes (which somehow represents all Wall Street, if not all 'bankers'), they should stop trying to direct investment via tax policy, and treat it all as ordinary income.
6 comments:
Treating it all as ordinary income was what the 1986 tax reform act did, if memory serves. Of course, the top tax rate then was 28%.
I've been spending quite a bit of time thinking about CPPI-based strategies. I tested it on a long history of data and my implementation gave something like 3-4% alpha a year over the past forty or so years.
I don't think of it like a dynamic put option. I prefer to think about it like a dynamic way to adjust the risk aversion coefficient in optimization. This means any mutual fund investor could implement it even if they were constrained to not hold futures or less than x% cash. Most of the time, I would want to keep the risk aversion coefficient such that I would be pretty close to following the benchmark. And obviously since this is done with optimization, you could still incorporate taxes or transaction costs.
Let's say I don't want to lose more than my 95% VaR over some horizon. As I approach that amount, I would want my risk aversion coefficient to go to infinity. This means that only a small percent of the time, when the declines are serious, would you really want to make the portfolio more conservative.
IMO, the two biggest worries are 1) how should you react to an extreme event and 2) how do you get back in. For 1, I think you should reduce the impact of outliers when calculating the returns for the purposes of the strategy. For 2, I think rather than using n number of prior periods, you could exponentially weigh the newest ones. Together these would mean it would take sustained declines to become more conservative and as they get farther away the declines become less important.
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Eric,
Great point about how the varying tax treatment of assets held for differing lengths of time creates inefficiencies that at least in part serve to enrich middlemen who frankly do not need government help in getting richer.
Any chance of pulling many of your finance-related government distortions concepts into one post?
Very nice post here, very useful information. This explains a lot about low risk investing. Thanks for sharing this.
Enjoyed the post. Could you give more info on the speaker and or paper? Is there a link available?
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