Monday, November 07, 2011

Cochrane on Alpha-Beta

Quantivity glowing quotes John Cochrane:

I tried telling a hedge fund manager, “You don’t have alpha. I can replicate your returns with a value-growth, momentum, currency and term carry, and short-vol strategy.” He said, “‘Exotic beta’ is my alpha. I understand those systematic factors and know how to trade them. You don’t.” He has a point. How many investors have even thought through their exposures to carry-trade or short-volatility “systematic risks,” let alone have the ability to program computers to execute such strategies as “passive,” mechanical investments? To an investor who has not heard of it and holds the market index, a new factor is alpha. And that alpha has nothing to do with informational inefficiency.

Most active management and performance evaluation just is not well described by the alpha-beta, information-systematic, selection-style split anymore. There is no “alpha.” There is just beta you understand and beta you don’t understand, and beta you are positioned to buy vs. beta you are already exposed to and should sell.

I don't find this very profound. If the carry trade or shorting the VXX is a beta trade and makes a risk premium, investors should be indifferent to it. The risk premium is an even trade of premium for risk (or rebate for insurance). He's assuming that most people would love to earn the returns from the carry trade or shorting the VXX, and I suspect he's right, but that's because it's not a risk premium, rather, it's simply an opportunity.

Ever since the small cap effect was discovered, people have been attracted to it as an asset class because it offered higher returns. Dimensional Fund Advisors started with a small cap fund. Now, if the 'risk premium' story were true, it would be just as interesting for investors to take the other side, to buy insurance against whatever risk these things were providing a return premium for (these other factors tend to have medians of zero, not 1 as in the CAPM beta). Such opportunities are never sold that way, and investors don't want to pay for these things by shorting them.


Quantivity said...

Eric, I believe we may be saying the same thing: risk factors are interesting not because they express an intrinsic risk-reward relationship (which I disbelieve), but rather because they proxy juice.

While this observation is indeed hardly profound, what is amusing and warrants citation is such was quoted by a Chicago school academic.

All that said, short vol appears to counterpoint your 3rd paragraph: lots of folks happily buy "insurance" in form of index puts (or vol swaps, etc). Also in this case, put buying can be mere hedging and thus framed agnostic to any risk-reward hypothesis.

Eric Falkenstein said...

Well, I agree that it's an interesting point made by Cochrane, but I think he's trying to flatter some of his wealthier patrons. As per index puts, some truly do buy puts for risk reduction to be sure, but I think just as many sell index calls for the same reason: to increase returns on their base portfolio. But, option players are diverse, though mostly deluded.

Anonymous said...

Yes, if something is a risk premium someone should be taking the other side. But it doesn't have to be explicit. For instance, if merger-arb offers a positive E[r] (net of equity market beta) because it basically sells insurance, you don't need to see "negative" merger arb products in the market to make this true.

Eric Falkenstein said...

True, but you still only get what you pay for, so should be indifferent to the return (which presumably merely is compensation for unpleasant risk). Most people who can generate significant merger arb returns don't think this way, they just see 'absolute return.'

Anonymous said...

Yes, but most people generating significant merger arb returns are wrong about it, so quoting them isn't a good argument. When this was a relativley unknown strategy many years ago it was fair to call it alpha. Now, today, most merger arb managers own very diversified portfolios and are delivering a merger arb "beta" (whether it's true risk or a highly replicable form of alpha) and charging way too much for it. Of course they want to ignore this issue and call it "absolute return"...

Also, you really think Cochrane is altering his comments to flatter "wealthy patrons"? Who? This seems like a crazy comment to me. Cochrane doesn't seem to alter any of his comments to please anyone.

Aaron Brown said...

I don't understand the "investors should be indifferent" point. In the standard formulation, I will like any asset that can increase my portfolio expected return without increasing my standard deviation. The return of that asset may represent a fair risk premium to the marginal holder, but if I currently hold none, the asset has excess expected return from my point of view.

I agree with Anonymous that there are negative exotic Beta products in the market, just usually not explicit. Index funds that sell the target and buy the acquirer immediately upon merger announcements are negative merger arb players. Investors who limit their holdings to stocks with market caps over $2 billion are negative small cap players. Companies that issue convertible bonds incorporating underpriced options are negative convert arb players.

I think the key isn't what you think, it's what the person on the other side thinks. Beta is earned from people who think they are earning Beta, Alpha is earned from people who think they are earning Alpha. With Beta, it's possible for both sides to be correct and happy, they just have diffent numeraires. With Alpha, one side is wrong.

Eric Falkenstein said...

Anon: everyone is susceptible to wanting to flatter powerful people.

Aaron: In Cochrane's universe, predictable risk premium are achieved only via loading up on those priced factors (aka betas). These are predictable only because they generate some systematic expected covariance with unidentified risk factors (eg,consumption/wealth ratio, ???). These priced factors are orthogonal to portfolio stdevs empirically (ergo low vol premium). Now, with heterogeneous agents you can get people who basically love cheap wine's unique taste and get it at a low price, but with standard identical agents, everyone has the same preferences, and their covariances with the risk factors are identical at the margin regardless of their current holdings.

Dave said...

What he means is that it's alpha when he and his clients are investing in it, but by the time you and me and the public get to it, it's only beta.

Part of that early alpha is the ponzi effect of the trend followers.

IMO that's the main investment hypothesis of the exotic financial instrument crowd.