Low Volatility Conference

Last Friday I spoke at a Robeco seminar on ‘low volatility’ (note the calm low-vol investor within a panicking buffalo herd). Why did I speak? Well, I have corresponded with Pim van Vliet for a while, as there aren't a lot of us 'low vol' researchers out there, so we tend to appreciate each other's work. He and Arlette van Ditshuizen run some of their low volatility portfolios.

The strategy is based on the well-documented fact that there is no obvious risk premium within equities. This implies that you can generate a dominant Sharpe ratio by simply focusing on only those stocks with low volatility. Reduce volatility by 33% relative to the indices (very doable), and you increase your Sharpe 50%!

Now, a slightly less obvious benefit of the low volatility focus is that the return is higher too, which was most prominently demonstrated in a series of papers by Ang et al in the Journal of Finance. You can download relevant data from my betaarbitrage.com website here, where I have beta portfolios since 1962, and minimum variance portfolios since 1998. Beta, total volatility, idiosyncratic volatility, it doesn’t matter, the highest of that stuff will have a lower return than average. Thus, removing them raises the portfolio return.

My talk focused on the idea that risk and return are not correlated in practice. This was a theme of my book Finding Alpha, and so I went over my empirical proof, which is to present the large scope of data that contradict a positive risk-return relationship, about 20 different asset classes. If risk and return are empirically uncorrelated, low volatility investing is a rather straightforward normative implication of what a rational investor should do, so clearly my invite served to help their argument and I was only too happy to shill for the truth.

The ultimate test of an economic theory is its out of sample performance, and this is perhaps mostit is most successful. I documented it in my 1994 dissertation, using data from 1926-1992 (you merely had to control for price or size, and it shows up). I then set up a C-corp that invested successfully on this principle from 1996-2001. I then worked at a hedge fund, and while I can’t say what or how I did, my old employer Telluride legally tried to prevent me from using ‘volatility’ ever again, because they thought it was valuable (and, creatively, their 'property’). So, I’ll just let my rational reader infer what I did and how well it worked for that period. Now, Robeco has shown it has worked from 2007-present, as the Robeco European Conservative Equity fund recently garnered the coveted ‘5 star’ Morningstar rating. That collection of real-time success is more compelling than any GMM test, because it is too easy to fit a specific historical sample using specific conception of volatility or really anything.

Vanguard became very powerful because they were the first big institution to really believe in the value of index funds relative to active managers. A key was, John Bogle , the CEO, really believed it, having written a senior thesis at Princeton on the subject decades earlier. Robeco has several researchers who all believe in the dominance of low volatility investing, and being right on a basic principle like this makes it a lot easier to be tactically proficient. I hope they can keep the imitators at bay, because I've sent innumerable letters and made presentations to funds that have all been veriy dismissive of this volatility finding. Thus, I would prefer they pay for their late-coming to he facts, because their crowd has been singularly unhelpful to those of us trying to sell the world, in academia or in the private sector, on this idea.

Given your average manager lags the indices by 1-2%, and has higher volatility than the indices, index investing does not offer wildly better performance than active investing, but it is clearly better. The case for low volatility portfolios is even more compelling in a Sharpe ratio sense, because there you increase returns by 1-4%, and lower volatility by 30%. One fund manager at the seminar discussed how they were now allocating 30% of their portfolio to low volatility investing. I suspect more and more institutions will find this a good idea, and it’s going to be a big trend.

Crony Capitalism in America

Big companies have always tried to curry favor with government, because their activities perforce are highly influenced by government behavior. Thus, it may seem priggish to think that big companies should be totally outside of politics, and simply react to the environment. Successful large companies may have to play the game, in the same way politicians have to mouth cliches, and promise generally unrealistic objectives.

Yet, I still find it highly disingenuous, hypocritical, and unhelpful to the general commonweal. Fine. They are still pandering pond scum. Not that nationalizing large private companies is better: I'd rather have a scheming FedEx lobbyist than a scheming US Postal Service exec driving policy. Our political process creates too much power in Washington, and everyone who focuses there is either is a sell-out or an empty suit. That this must be so given our political system, which has arisen somewhat endogenously and seems no more corrupt than other systems, is not a reason to like it. "Is" constrains "ought", it does not define it.

So, a reason to hate Vanguard, where a 'vanguard blogger' was defending the stimulus, and found to be a heavy Democratic supporter. That isn't the worst of it:

Vanguard PAC contributions I reviewed is how clear it is that the PAC money (unlike Mr. Utkus's) is not ideological, it's transactional. For example, the PAC gave $30,000 in this cycle to the Democratic Congressional Campaign Committee and $30,000 to the Democratic Senatorial Campaign Committee — and it also gave $30,000 this cycle to the National Republican Congressional Committee and the National Republican Senatorial Committee.

Where the Risk Premium Thinking Leads You

As they say, somethings are so silly on the highly educated can believe them. John Campbell, an archetype of conventional financial academic thinking, has an interesting yet absurd piece on why the low yields of US treasuries makes sense. He starts off with the standard view, that yields of government bonds are due to three things

• expected real interest rates
  
• expected inflation
  
• risk premium
  

As current interest rates are around 2.5%, and current inflation expectations are around 3%, even with a slight convexity adjustment there's a negative real expected return here. To guys like Campbell, that means, bonds are some kind of insurance, because the only reason investors would accept this is if they pay off in a very bad state of nature, just as you pay for car insurance. Specifically, everyone is suposedly afraid of a recession that would also bring with it deflation.

While the CAPM betas of bonds have historically been positive, they have been negative lately. If you believed in the CAPM, that would mean the expected negative return makes sense, it is a negative 'risk premium'. Of course, the positive beta previously did not explain why bonds cratered from 1960 to 1980, and the CAPM does not work at all within equities, the arena it was designed for. It also does not work in corporate bonds, REITs, options, etc. But looked at in isolation it is a plausible explanation, and hope springs eternal.

I think a better explanation of the current interest rates is that the Federal Reserve has been buying hundreds of billions of dollars in US Treasuries. Considering, they have an infinite supply of capital to do this (they create the money when they write the check), the market is not going to offset this via expectations of future inflation. So, the expectations are there, but US Treasuries are a rigged market, with one huge buyer debasing the world's most powerful currency because it's in the standard Keynesian manual for how to treat excess unemployment when inflation is currently low. Once the evidence of this short-sighted policy becomes clear, the inflation toothpaste will be out of the tube, and on to the next bubble-crash.

That is, the expected return on bonds is negative, because bonds are in a Fed-supported bubble. Just look at gold to see what an inflation sensitive market looks like without Fed shenanigans. US Treasuries are not insurance any more than tech stocks were insurance in 1999.

Krugman Demotivator

From Krugman's NYTimes post in 2002, available here.

When the results of this advice became apparent in 2008, he was awarded the Nobel Prize in Economics.

Buffett's Hire Doesn't Scale

Buffett's replacement Todd Combs seems like an earnest, smart stock picker. But a $100B fund doesn't need a stock picker, they need a deal-maker, a business manager, corporate strategist. Surely Buffett only grew into this role, starting as a pure stock picker, but he is truly sui generis, hardly something you can expect from anyone.

From the WSJ, it appears that Combs basically has been a portfolio manager since 2006, focusing on banks. He did relatively well in 2007 and 2008, when he shorted banks, and has underperformed since. Indeed, his 'best' year was in 2008, when he had a 5% loss: as I have argued repeatedly, relative risk is what truly matters, and if this is true the risk premium should not exist, which is consistent with reality. Ultimately, he has a very short resume, and from a Bayesian perspective, a guy who predicted an objectively improbable event--banks up to 2007 were relative outperformers--is probably a lucky crank, not a genius. The banking crisis, like every other crisis, was different. After all, if aliens come back on December 21 2012 as the Mayans 'predicted', the guys who will have seen it all coming are currently in their mom's basement with tinfoil on their heads.

Moving $400MM around is a lot different than moving $100B around. You simply can't short individual names to make much of a difference with $100B. Most things don't scale, which is spider-man does not make any sense: just because a spider can lift 40 times his weight does not imply a 200 pound spider could lift 8000 pounds. My family is organized using Marxist principles ('from each according to his ability...'), yet I don't think for a minute this would work in my neighborhood, let alone nation.

It reminds me of a bond portfolio analyst I knew who found himself running a $2B convertible bond fund. At $2B, he simply could not cherry-pick a large enough set of securities he could as a junior analyst asked to come up with 5 good trades. So, he basically took industry and duration bets when he became a portfolio manager, making his past experience rather irrelevant. His fund blew up during the first market contraction in his asset class, but he pocketed tens of millions of dollars.

I would rather pick someone from the distressed or risk-arb hedge fund pool to manage $100B, because they are thinking about corporate strategy, like selling divisions, bankruptcy, mergers, finding CEO who are great or horrible.

Fund Manager Commits Suicide, SEC Investigates

A local story about fund manager Robert Markman, who ran a classic Ponzi scheme. It reminds one of Henry Blodget:

The college theater major oversaw $700 million in assets, fielded calls from the nation's top financial press, and held seminars for other advisers seeking to capture his magic.

But he succumbed to his own hype, often promising more than he could deliver. He told employees they would be millionaires after just a few years of working with him.

And he secretly guaranteed a clique of favored investors 10 percent annual returns in what he called the "house accounts."

These 'house accounts' were Ponzi money, inflows used to prop up other funds. Eventually, this cunning plan ran out of money. He was a zero-alpha fraud from day one, and when he finally was about to be exposed, he killed himself, writing a self-serving suicide note highlighting that he died feeling sorry for himself, as if his calculated fraud that created his entire career was some peccadillo that would be blown out of proportion.

I don't see why the SEC bothers with 'enforcement', rather, they should merely have a legal team that meets out punishment after the fact. For cases like Madoff or Markman (above) where all the money is gone and no restitution can be made, at the very least if the jerk does not kill himself he can die in jail.

But we should not waste money on the presumption that SEC enforcement actually sniffs out frauds before they blow up. In 2005, Harry Markopolous wrote a 21-page memo to SEC regulators about Bernie Madoff entitled: "The World's Largest Hedge Fund is a Fraud." Nothing happened. The regional SEC office was aware since 1997 that Allen Stanford was likely conducting a Ponzi scheme, but no SEC action took place until 12 years later when his Ponzi scheme was revealed via a lack of funds, costing $8 billion. Too little too late.

They might as well admit they are there to attach fines and jail time on the obviously guilty. It is so easy to fool the SEC, they only highlight their obliviousness by suggesting their activity is anything other than post hoc.

Sometimes It Just Takes One Mistake

Sports are so compelling because they embody the essence of life: meaningless at some level, but the competition, excellence, and courage are as good a collection of virtues one can observe. The key is that the excellence is refined, a mastery that takes skill and practice at something many others appreciate. I used to wrestle and keep up with college wrestling, but I really like the mixed martial arts as practiced in the UFC. This weekend's UFC had another classic bout, with the huge Brock Lesnar looking invincible, just like Fedor Emelianenko. He's just freaky strong, country strong. Once in a college wrestling match he broke his opponent's pelvic bone in a cradle.

But Cain Velasquez is really talented too, and highlights that in this sport no one is that much better than everyone else. To look at him next to Lesnar, you think, this guy's in trouble, but MMA fighting takes a lot more than strength and speed (though those are necessary and sometimes sufficient). Velasquez withstood Lesnar's initial assault, and then actually took Lesnar down with a nifty high crotch, in a move that didn't seem too flashy. That is, he made it look more like a slip than an actual offensive move. Then, coming from a wrestling background, Lesnar instinctively took a wrestler defense by getting to his base, a big mistake in mixed martial arts where striking and joint locks are in play. This opened him up to devastating strikes to the head that left him dazed. By the time Lesnar stood up he was dizzy, and Velasquez seized on this opportunity and finished him with strikes and a nice knee. Another very strategic match, where a small mistake leads to catastrophic failure.

In contrast, tonight I took my boys to a professional wrestling match, as they find this great fun (and its fun for me to watch them having fun). I find it all rather hokey, obviously scripted, and so lacking any suspense. Strangely, there were a lot of 'retarded' people in attendance (eg, Down's syndrome), so the fan base is truly people with mental ages of around 11.

Robo-Signer Pretexts

At the center of your being you have the answer; you know who you are and you know what you want
~Lao Tzu

People have objectives, and are very good at rationalizing why these objectives are efficient and just. As Lao Tzu noted, if you know what you want, you know the answer too. [However, Tzu seems to think this is a good thing, as if our authentic, innermost wants are better than those that come after reasoning].

The robo-signer kerfluffle is a pretext to pander to the mob, just like razing kulaks back in the good old days. People like Paul Krugman, who's id leads his superego rather directly, suggest that those signatures affirming that some person owns the mortgage on some property and hasn't paid, may not have had first-hand information to that effect. They may have been using hearsay information. This is the kind of legal breach is hardly a grand problem that must be addressed prior to further foreclosures. How many of you have clicked 'I have read the EULA agreement' when downloading software without actually doing so? Is that a problem?

The main issue is in any foreclosure is: 'When is the last time you made a mortgage payment?' If it was several months ago, the rest doesn't matter. If people paid their mortgage bills, robo-signers would not be problems, and if they don't pay their mortgage bills, there will be a problem. Having the servicer spend a day on their affidavit won't make it any more accurate, the facts are pretty easy to see.

In my litigation experience I remember that it was rather pointless getting indignant about what my adversary was saying, because when dealing with someone who has bad faith, they won't be satisfied when you address their specific points. They would say 'this is about enforcing the law', as if a spreadsheet of the SPY returns since 2000, downloaded from Yahoo!, that I transferred to my home computer, was a violation of my confidentiality agreement. The specifics did not matter, it was the principle, they would say, the sanctity of contracts, the importance of protecting their property rights. Details being complicated, costly litigation commenced, which was the end game. For many people, an indefensible unstated principle is their end game, but because it is self-serving and petty, one can't say it directly. Thus, various pretexts are paraded as principle, and quickly forgotten once their damage has been done.

Renewable Resources Run Out

Matt Ridley, who wrote The Rational Optimist, was interviewed by Russ Roberts. This was an interesting insight:

There is not a single example of a nonrenewable resource that has run out. Nobody ran out of stone in the stone age, iron in the iron age, or bronze in the bronze age. That's not why these ages peter out, it's rather because we move on to something else ..whereas renewable resources tend to run out, like whales, passenger pigeons, and white pines.

Disingenuous Hair Splitting

When I was learning economics, monetarism was on the wane. The 1981 recession brought forth a big change in velocity that did not conform to the standard model of monetarism, which is that MV=PT, and that the growth in V was relatively stable. Yet, I came in contact with several monetarist economists eager to save the theory, by saying that 'money' was not M1, but rather, M2, or monetary aggregates per capita. Hair splitting did not save the quantity theory, rather, it was a typical tactic by true believers to save a bad idea (of course, at a log level the quantity theory still works very well).

I was reminded of this when watching economist Glenn Loury debating legal scholar Amy Wax on Bloggingheads about Amy's new book, Race, Wrong, and Remedies. Her argument is basically that regardless of why blacks are currently socially disadvantaged, they must make changes necessary for them to improve their situation, such as getting married before having children, not committing crime. America cannot do these things for them, so using 'remedies law' she basically says black culture is the key to improving black America. Glenn's big criticism of her point was classic hair splitting, using highfalutin diction with banal casuistry, so that if you actually understand what he says, he does not have a coherent point.



This is the Jackie Chiles school of speaking, made famous by lawyer Johnny Cochrane and academics Michael Eric Dyson and Cornell West. It's kind of funny once you see them start talking faster than they are thinking because their arguments go into dead ends, forcing them into bizarre run-on sentences because they are hoping to stop after making a point, but one rarely arrives.

Ed Miller's Curse

In 1977, Edward Miller presented a model where investors with different opinions were buying assets. He noted that in such a case, an asset with a greater dispersion of opinion would have higher prices, given the same average expected return. Looking below at the graph from that article, you see that the steep line shows the distribution of valuation when there is a great divergence of opinion. In such a a case, when you need finite amount $X to buy your stock, the more deluded the buyers are the better.



It's a pretty simple idea. In 1971 some engineers at Atlantic Richfield noted that there's a winner's curse in drilling rights: those who won an auction were most likely to have overestimated its value. The petroleum engineers noted that oil companies suffered unexpectedly low returns in early Outer Continental Shelf (OCS) oil lease auctions. OCS auctions were common value auctions, where value of the oil in the ground is essentially the same to all bidders. Each bidder has their own estimate of the (unknown) value at the time that they bid. Even if these estimates are unbiased, bidders must account for the informational content inherent in winning the auction: the winner’s estimate of value is (one of) the highest estimates. If bidders ignore this adverse selection effect inherent in winning the auction, it will result in below normal or even negative profits.

Now, this isn't rational, and Richard Thaler noted it as a potential anomaly in asset markets back in 1988. People should adjust their bid so that conditional upon winning, their private estimate does not overpay for the asset in question. This is actually very difficult to do in practice, but not that, if you win an auction with 3 people, that's a lot less scary than winning an auction with 300. The relevance of the winner's curse to asset markets was 'partial equilibrium' analysis, supposedly irrelevant because of arbitrage.

Yet, Ed Miller continued to note that his argument seemed to make sense. In 2001 article in the Journal of Portfolio Management, he noted that

An implication of this theory is that investors can improve their return relative to risk by exploiting the flatness of the security market line.

That was good advice in 2001, and 1977. Several esteemedd economic papers now reference tho 1977 article as why there are low returns for highly volatile assets, like IPOs.

Misery Loves Company

Recently, entrepreneurial lawyers have taken up the cause of renters who stopped paying their mortgages, as if they are somehow the victim in this mortgage crisis. The mortgage crisis has certainly generated a lot of damage, but those who bought houses with teaser rates with little money down are hardly victims (Michael Moore compares them to rape victims), but rather, scammers looking for a free lunch (buying a home with little money down is an underpriced option on home values).


A chart in the WSJ shows the increase in time it takes between when a homeowner stops paying his mortgage, and when a bank can actually take possession of the property. The average time over all states in 478, and the latest activity to help the non-paying renters will probably boost that further.

The families of the 9/11 victims averaged $1.8MM for their injustice, the 33 victims of the USS Cole that were killed by Al Quada got about $0.4MM, and those who were killed idiosyncratically generally received nothing. The key to being a successful victim is to be a victim others can empathize with.

I remember in my litigation I was a modestly rich guy fending off litigation from my former employer, a very (~100x more) rich guy. While I was in my career time out I spoke with a state legislator about state law, noting that unlike other states a party did not have to specify the intellectual property in question when alleging a violation of said property. Now, any proposed legislation would not affect me, but I thought the status quo was unjust. The law made confidentiality agreements perpetual non-competes for litigious parties with sufficient means (you can read more here). The legislator told me straight up: "it does not happen enough to a group anyone cares about'. True enough. Who cares about a hedge fund employee getting screwed? When my lawyer told the judge the allegations against me were costly and prevented my ability to work she said "Can't he golf?", and the courtroom laughed. Sympathy is for the historically disadvantaged, the poor, and people aligned with such groups, and sympathy often leads to specific redress if not subsidy.

On the other hand, when everyone is a victim, by definition you can't give yourselves a boatload of money, because it has to come from somewhere else. Thus, you have the Laffer curve of redistribution where if you suffer a bizarre injustice or injury, you get no money or sympathy, and if everyone suffers an injury, you have to suck it up (though, like our 'greatest generation' you can capture sympathy if not respect from future generations about your suffering later).

A key here is the conflation of injustice and injury. Injustice implies a third party was negligent or malicious, whereas injury is just random bad luck. From a societal point of view it makes a difference because we ought to compensate victims of injustice and they get to take the moral high ground, while victims of bad luck just get put into standard welfare programs. In practice, the difference is whether one side's affiliation can provide useful indirect support as a PR prop or voting block, or whether one party himself can provide useful direct support. The facts in disputes are pretty messy, requiring more effort than most are willing to apply, but the benefits are usually straightforward, and you can predict interested people's inference of messy facts pretty well based on which inference offers them greater benefits.

Currently, the homeowners are changing the mortgage contract ex post because lawyers and politicians find them useful muckraking props for their power and profit grabs. Prior default curves for mortgage cohorts are now totally irrelevant because there is now little stigma for defaulting on a mortgage--rather the opposite--and you get to live rent free for a longer time if you stop paying. Pre-2006 was a different world for mortgage behavior. Such expropriations are not free, however, they get built into current prices and contracts, and so make things much worse because sellers and lenders rationally anticipate lower recovery rates and higher default rates. The current housing morass will not get better until government stops 'helping'.

No Nobel for Art Laffer, Ever

A good way to think about the state of economics, is to note the disparity between the treatment of the Laffer curve and Nobel prize winning economics.

In this year's Nobel highlighted work that formalized the effects of search on labor dynamics. Basically, if you have people with unknown productivity searching for jobs, they should not take the first job offered; firms should fire those people with below-average productivity. That's a good insight. Too often people look at the unemployed as a homogeneous lot, who are affected by labor demand like plankton affected by the tides.

Yet as a formal model, it is ambiguous, as all formal economic models are. First-order and second order effects offset each other, making their relevance an empirical matter. Thus, wage subsidies, minimum wages, laws making it difficult to fire employees, have ambiguous effects on society. Mortensen's 1970 model did not make it any easier to answer these questions, which is why societies are not any clearer on how to best alleviate unemployment today as they were in 1975. He just noted unemployment is rational for someone waiting for a good job. Again, a good idea.



Art Laffer famously presented his idea that tax revenues are at first increasing, then decreasing in tax rates, on a cocktail napkin, when arguing about the president Gerald Ford's tax increase (ie, 1974). This too is a good idea. This too, is an empirical issue, as we can be either at a point where revenue is increasing in the marginal rate, or decreasing. Even if the curve is increasing, its slope is important, especially because maximizing government revenue is not the same as maximizing societal welfare.

Yet Art Laffer will never win the Nobel prize. His idea is as insightful and has the same empirical limitations as the modeling of labor search on unemployment or any of the other economics Nobels. If you think Laffer's point is too uncertain to be Nobel-worthy, you are putting to much confidence in the Nobel brand (they are all that uncertain); if you think Laffer's point is not sufficiently rigorous, I think you are confusing rigor with understanding.

Nobel prize winning work has the imprimatur of 'science' because it spawns elegant models. The models are no more predictive or instructive than the Laffer curve, just they lend themselves to infinite amounts of rigor so it can then it looks like physics, which is the end game (looking like physics). Rewarding formalism that is no more precise than a Laffer curve has been really bad for understanding economic systems. The Laffer curve is marginalized by economists for its unpretentious honesty, whereas the dynamic general equilibrium search models are more misleading as to how precise they are or can be. This makes economics less fruitful.

The Genius in All of Us

Strangely, most people can read this:

Can you raed this? Olny 55 plepoe out of 100 can.I cdnuolt blveiee that I cluod aulaclty uesdnatnrd what I was rdanieg. The phaonmneal pweor of the hmuan mnid, aoccdrnig to a rescheearch at Cmabrigde Uinervtisy, it dseno't mtaetr in what oerdr the ltteres in a word are, the olny iproamtnt tihng is that the frsit and last ltteer be in the rghit pclae. I awlyas tghuhot slpeling was ipmorantt!

Now, a computer would have a very hard time with this, but as a native English speaker I read this with ease. As Marvin Minsky has pointed out (no relation to Hyman), computers still can't tell the difference between a dog and a cat, something my 3 year old daughter does with ease. The theme of Godel, Escher, Bach by Doug Hofstadter is that the mind is insanely good at finding patterns, and what is easy for us can be really difficult logically, and what is hard for us is easy for computers.

When I'm peevish, I'm amazed how how stupid most people are, how little original thought is created and appreciated, how faux rigor from false assumptions does not overcome them, how many phonies there are. But then, I remember stuff like this, and think that most us are quite clever.

Econ Nobel Not Worthy

Science is about recipes, all the rest is literature. E=MC^2, F=G*m1*m2/r^2, PV=nrt, etc. That's science, and good new models are bricks that are built upon. In 1969 when they started the Nobel Prize, they had reasonable reason to believe that economics was a just like physics and biology, in that game theory, macroeconomic modeling, and Arrow and Debreu's Theory of Value, seemed to suggest that economics was a system of logic and precision little different than physics.

Alas, it was not to be so. Most economic truths are found via common sense and experience. As Milton Friedman noted, it wasn't his arguments that convinced anyone of the supremacy of capitalism, but the manifest failure of the socialist economies. With hindsight, we can identify we socialism failed theoretically (the inability to decentralize incentives), but that had to conspicuously happen to convince anyone.

When I was in grad school, the top financial work consisted of applying Banach Spaces or various GMM tests to the data. The focus was the technique, not the data. Shanken (1985), Gibbons (1982), and Gibbons, Ross, and Shanken (1989) tested the CAPM by whether or not the market is mean-variance efficient. They applied Wald, Maximum Likelihood, and Lagrange Multiplier tests, as if this mélange would be better than just one test.

The thought was these approaches would be fruitful because they were so rigorous. Yet they did not lead to any fruitful improvements in finance. They did not highlight what was wrong with the CAPM, only that, it didn't work at some level of exactness no one cared about. Fama's rejection of the CAPM simply sorted companies by size and beta, and highlighted that beta was then uncorrelated with average returns.

Fama was consider unrigorous by my professors back then, part of the unsophisticated old guard. Who knew that subsequently, he would be seen as the theoretical and empirical expert. The key was not some subtle distinction between the Wald and Lagrange multiplier test, but rather, a simple correlation in the data between size and beta that made the correlation between beta and returns seem plausible. When you adjusted for this, it was not plausible. This did not take advanced econometric techniques.

Many good things are combinations, and good financial insights come from good statistics and fundamental knowledge of the data. Adjusting the data for delisting biases (Shumway, 1997), not using daily data dominated by low prices (Stambaugh and Blume, 1983), are key adjustments that totally change results, and though we look at them now with obvious hindsight, one must remember that for 10 years people did not know about them.

Finance is like wine in that while experts talk about sophisticated concepts the basics are simple things like clean barrels and clean data. Getting economists back to simple stuff, basic data analysis that corrects for various omitted variables, is the best way to find important economic truths. It's the data, not the process, that matters more. There simply aren't many economic equations, not enough to make the field a science, so it's more of seeing empirical tendencies, as almost everything is 'an empirical issue' with theoretical offsetting effects. Many thought that powerful techniques could avoid these issues, and in fact those concentrating on these adjustments were considered not as productive as those doing yeoman's work with the data. The scientism of economics that Hayek warned about has been very counterproductive to economics.

Heart without a Brain

Here's Michael Moore promoting his movie about the 2008 financial crisis, in Capitalism: A Love Story, at an interview with Canada's Q TV:

Q: There are a lot of scenes where people lose their homes to foreclosure...The remedy presented is the banks should forgive these loans, even if they are unpaid.
At what point should an individual be held responsible for paying back the loan?

Moore: At what point should an individual be held responsible for being raped? Are you saying the victim wore too short of a skirt? ...the number one reason people are being thrown out of their home is medical bills...

First, note the really bad analogy. A foreclosure, is not 'like' rape, excepting that 'an unfortunate thing happened'. But to infuse with such an absurd, and vivid, analogy highlights he is more driven by emotion than reason, hoping to short-circuit criticism in the naive way Nazi analogies are generated by young debaters.

While I don't doubt Moore's intentions, he would make life worse for everyone on an absolute scale. The Kantian idea that you judge everything on good intentions is not absurd, after all it's hard to fault someone for ignorance because in many cases ignorance is not a choice, but rather the effect of circumstance. Yet here, Moore is simply wrong on the facts here. Medical bills did not rise appreciably in 2007-08. The only evidence that medical bills causes foreclosure is that among people who will be interviewed after a foreclosure, if you ask them why, their answers are predictably self serving (every bankrupt company CEO thinks he was 'screwed' by his banker).

But still, I imagine many on the left would find that one nice thing about poor places like Gabon and Bangladesh is that there is less economic inequality; if the US were 25% poorer but had no billionaires, it would be preferable. In that case, I guess I just have different preferences than these people.

Government Stimulus in Action

This harebrained plan solves nothing:

Unemployed homeowners in Massachusetts will be able to take out interest-free loans of up to $50,000 to help them make mortgage payments, under a $1 billion federal program unveiled today in Roxbury by the US Department of Housing and Urban Development...The effort, called the Emergency Homeowner Loan Program, is meant to supplement a $7.6 billion program launched by the US Treasury Department... To qualify for loans of up to two years, borrowers must have suffered a significant drop in income and be at least three months behind on mortgage payments. They also must demonstrate "a reasonable likelihood of being able to resume" payments within two years. Applications will be accepted until the end of the year.

Economic policy should be about creating structures for sustainable economic patterns of trade. This is all about trying to do something, hoping the good intentions will be sufficient to gain public support.

Why Volatility Innovation Can't Save the Risk Premium

I noted that a paper referenced the fact that an asset's correlation with volatility changes is a priced risk factor. Thus, instead of the CAPM, where you have

E(R_i)=R_i+E*Beta*(R_m-R_f)

You have

E(R_i)=R_f+E*Beta*(ShortVolatilityInnovation)

In the 'volatility innovation' story of risk, you are worried about not some market return proxy, but rather some volatility index. We all wish we had assets that appreciated when markets go crazy, like in 2001 or 2008, but we would have to pay a premium for that, which is why (supposedly) there's a market premium for it.

Research on option strategies tend to find that selling volatility does make more of a premium than buying volatility. There are large transaction costs to this direct strategy, especially historically, so it is not clear how economically meaningful this all is in terms of a realizable premium to selling volatility. See Sophie Ni (2008), Bonderanko (2003), or Shumway and Coval (2000), for data on the returns from selling volatility (all w/o good data on transaction costs). The VIX index is derived from 30 day implied volatilities on the SPX index. Since 1995 the average has been 21.5, whereas realized vol was 20.3. Thus, it seems you could have made money 1 vol selling at-the-money volatility.

Note this is the 'selling Black Swans' strategy, or Victor Niederhoffer as opposed to Nassim Taleb. As we know from Niederhoffer's record, this strategy can be dangerous, with fat tails wiping out years of returns, so it might not be a good strategy everything considered. I have backtested such strategies using historical option data and find that over time selling vol makes a decent profit. Just good luck telling your investors that after events like in 1987, 2001, or 2008, when you get crushed. One paper argues that 'jump risk' underlies the premium to selling volatility, and that makes sense, in that, you simply can't sell volatility as easily as buy, because of the capital requirements, so, return per underlying might look different, but on capital required via the market, not so different.

The problem with volatility correlations saving the risk premium story is that it is highly correlated with the market. Here is a daily return scatterplot:


and a monthly:


If sensitivity to volatility innovations captures the risk premium, then the flat (at best!) return to standard CAPM beta implies there must be some risk factor that offsets the negative correlation between volatility and the market. Whatever that could be makes absolutely no sense. That is, it probably had good returns in the October 1987, Sep 2001, and October 2008, yet still a positive average return. I'm open to suggestions, but this sounds the Flying Spaghetti Factor.

Note that a sign of an unsuccessful theory is that as the data become more clear, and more numerous, the theory becomes less clear. First, risk was the covariance with the stock market, but ever since then it has become more nuanced, and there's always a new proxy for the risk premium(s) that 'powerful new econometric techniques' are supposed to uncover.

John Kenneth Galbraith

Nice evisceration of John Kenneth Galbraith in the WSJ. He was wrong on all his major arguments, namely that the market was always overvalued and about to crash (from 1954 onward this was his familiar refrain),that large companies had huge advantages over small ones via their price setting ability and 'planning', and that those who argued against him were spouting 'conventional wisdom' (his liberalism was the conventional wisdom throughout his life). Lastly, he was fond of mentioning all the good things the Soviet Union did compared to the United States. He was always one of the world's most esteemed economist, highlighting that 'famous' doesn't mean 'profound'.

Galbraith was one of the first to criticize the capitalist economy for its prosperity, what he called private affluence, as if the new cars and computers being made were wastes of money relative to more spending on schools (really anything, as long as the government spent it). Hayek had a great comment on Galbraith in his essay The Non-Sequitur of the Dependence Effect:

I believe the author would agree that his argument turns upon the "Dependence Effect". The argument starts from the assertion that a great part of the wants, which are still unsatisfied in modern society are not wants which would be experienced spontaneously by the individual if left to himself but are wants which are created by the process by which they are satisfied. It is then represented as self-evident that for this reason such wants cannot be urgent or important. This crucial conclusion appears to be a complete non sequitur and it would seem that with it the whole argument of the book collapses.

The first part of the argument is of course perfectly true: we would not desire any of the amenities of civilization-or even of the most primitive culture - if we did not live in a society in which others provide them. The innate wants are probably confined to food shelter, and sex. All the rest we learn to desire because we see others enjoying various things. To say that a desire is not important because it is not innate is to say that the whole cultural achievement of man is not important.

Never Trust Experts

Science at some level contains essentials truths that are interesting and useful, a dominant alternative to ignorance and superstition. At the cutting edge, however, it's all about seeing what you believe, so it's mainly a trick of knowing what to prove, because a clever person can prove anything.

In an article on the Carry Trade, Menkhoff, Sarno, Scheling, and Schrimpf say they explain the positive returns to strategy via a 'risk premium'. This is how it is supposed to be, any identifiable return premium should be explainable in terms of risk alone.

So, here's a little throw-away line about prior work on volatility:

we investigate the empirical 2 performance of another risk factor: innovations in global FX volatility. This factor is a proxy for changes in market volatility suggested by the ICAPM theory, and is the analogue of the aggregate volatility risk factor used by Ang, Hodrick, Xing, and Zhang (2006) for pricing the cross section of stock returns. We show that global FX volatility is indeed a pervasive risk factor in the cross-section of FX excess returns.

OK, what they are saying is "There is no puzzle. It's all explainable in the standard framework. We use the risk factor 'innovations in volatility', which has been shown a relevant pricing factor back in 2006". The problem is that the paper referenced showed that high volatility innovation is correlated with lower returns. Further, higher volatility ex-innovation is correlated with lower returns. Indeed, the 'volatility innovations' ruse is clearly an attempt to torture the data to tell it what the authors wanted. Here, the risk premium actually makes sense (if you believe their results, and I'm skeptical they are robust as the carry trade did well in years like 2001-2002, and poorly in 1997-2000; there isn't as much data as you might think; eyeball below and see if it looks like returns are positively correlated with 'good times'). If volatility innovation is a priced risk factor, it doesn't make sense in general because in other markets volatility and things correlated with it are inversely related to returns.



So, financial economists appear to have shown again that some asset pricing pattern can totally be explained via some correlation with some new metric of risk that is strangely parochial to that specific asset class (that's not how it should work). They all know that returns are totally explained via risk premiums, as defined as covariances with proxies of their marginal utility. So, when convoluted tendentious drivel like this shows up again and again, it is considered serious research. I say, it's only interesting to academics if you believe the risk-premium theory (99%+ economists).

This search for the evanescent risk premium that appears as an ephemeral ghost, yet is omnipresent and very important, is one of the myths of our age. I've got better things to do.