Thursday, June 28, 2012

Mandates are Taxes

Perhaps the reasoning that 'mandate are taxes' in Judge Robert's decision for Obamacare will make it more accepted that taxes are a radical understatement for the size of government. Clearly, it is easier to proxy the size of government with things like number of employees, or total revenue or spending, but that doesn't mean this is a sufficient statistic, just an easy one.

 A friend of mine is a CFO for a large company, and says they are not expanding into California because of the excessive amount of regulations in that state, making the total cost of development much higher than any simple metric of property values or wages. Currently the Equal Employment Opportunity Commission mandates that things like disparate impact among historically disadvantaged minorities, using criminal records in employment, or firing alcoholics, can be illegal. Home Depot's founder says that he could never have built up his company today with all the environmental and employment regulations. And then there's the Hoover Dam, which many like to show what government can do, but now could never be built because of current regulations.

Obama was pretty adamant that a mandate is not a tax, and this was a common argument. Now that this bill was salvaged via the argument that mandates are a tax, I at least hope there's a concession that a mandate is a tax.  Cliff Asness has an article on this point, presciently written days before the decision.   

Happy Tau Day

One of the more tragic path dependencies is that years ago someone defined π (aka pi) as ratio of the circumference of a circle to its diameter, as opposed to its radius. If you define τ(tau)=2π, it's like a presbyopic putting on reading glasses for the first time. It turns out, switching from π to τ makes a lot of other corollaries less convoluted, including the 'world's most beautiful formula' e=-1, which would be e=1.


Monday, June 25, 2012

The Envelope Theorem, Group Selection, and Cynical Framing

I'm rather fascinated by the concept of group selection, which seems rather important in explaining human behavior. I don't think it explains everything, but a lot. Steven Pinker just wrote an Edge piece criticizing it, and it is pretty good. His basic point is that unlike ants, human soldiers need a lot of prodding to kill themselves for the commonweal. Kin selection and reciprocal altruism, for Pinker, are sufficient to explain the superficial altruism one sees in society  In the comments section Herb Gintis replies, and he's an economist with a long interest in this debate; he favors the importance of group selection.

 I think a lot of this gets down to the envelope theorem, because if self and group selection mechanisms are operating, you will find something optimal for the self given the optimal group behavior, will also be optimal for the group given the optimal selfish behavior.  That is, take y* to be the optimal output, and x* to be the optimal value of x for any value of a.  Then


So, as with economics, it is often difficult to find easy tests.  That is, I'm sure for most instincts, one can rationalize them with selfish and groupish incentives.  I think a key proof would involve showing  that if you are competing with other individuals, it is not an equilibrium for there to be no coalitions; a coalition would outperform those not acting in concert, the way a collusion in Texas hold 'em can dominate non-colluding players.  Thus, it should be hard wired to collude because it is a dominant strategy if no one else is doing it, and perhaps even if everyone is doing it.  

In a tenuously related observation, Dan Dennet responded with an especially cynical focus.  First, he says to drop the 'group' prefix because it seems to support some 'vague and misguided ideas' that Dennet does not like.  As Jonathan Haidt emphasizes patriotism and religiosity of group selection, one can presume that's what Dennet is afraid of there.  He then suggests adding the word 'design'  into the selfish selection mechanism because the 'intelligent design' community has stumbled upon a good description of how biologic systems appear (ie, like they are designed, as admitted by Dawkins and Pinker), and he hates 'Intelligent Design'.

This is what reading George Lakoff does to people's thinking, gets them to focus on manipulating metaphors and focusing on higher truths as opposed to discussing ideas at hand, and that is a path to cynicism and nihilism. I agree that the big picture matters and very occasionally one has to be insincere or misleading to help a higher goal (eg, not overly criticizing your leaders when fighting Nazis and the battle is in doubt).  But  if you make them your primary focus you have simply become a shill for whatever big idea you chose years ago.

Consider the genius Lakoff's idea to rebrand taxes as community dues, an idea that didn't work because while we don't mind paying dues for clubs, unlike taxes, dues are voluntary. But because he's is so partisan he doesn't see the stupidity of his suggestion, and it has gone nowhere. Lakoff's latest riff on branding the health care fight, is especially funny because this master of language writes the following, which I could not decipher:
There is another metaphor trying to get onstage -- that the individual mandate levies a health care tax on all citizens, with exemptions for those with health care. The mandate wasn't called a tax, but because money is fungible, it is economically equivalent to a tax, and so it could be metaphorically considered a tax -- but only if the Supreme Decided 
Where the first metaphor would effectively kill the Affordable Care Act, the second could save it.
As George Orwell noted, the enemy of clear language is insincerity, and here he does want a mandate and all it implies, but does not want to say so.

Simple Theory on the College Premium

I'm sure a Yale economist could formalize this with set theory, but the idea is pretty straightforward. This is from Steve Postrel:

My hypothesis is that it is precisely the dumbing down of U.S. education over the last decades that explains the increase in willingness to pay for education. The mechanism is diminishing marginal returns to education.

 Typical graduate business school education has indeed become less rigorous over time, as has typical college education. But typical high school education has declined in quality just as much. As a result, the human capital difference between a college and high-school graduate has increased, because the first increments of education are more valuable on the job market than the later ones. It used to be that everybody could read and understand something like Orwell’s Animal Farm, but the typical college graduates could also understand Milton or Spencer. Now, nobody grasps Milton but only the college grads can process Animal Farm, and for employers the See Spot Run–>Animal Farm jump is more valuable than the Animal Farm–>Milton jump.

 So the value of a college education has increased even as its rigor has declined, because willingness to pay for quality is really willingness to pay for incremental quality.

I have a feeling that with the increased importance of programming, and the fact that programming skill is verifiable, smart kids will start arbing the skills premium, taking the $150k otherwise spent on college to start a business or buy a condo, and avoid those $50k/year schools that offer little.

Thursday, June 21, 2012

Investors Like Large Spreads, Says Broker

Here's a good example of someone who has learned to rationalize his self-interest so well he does not recognize when he is saying something absurd, from the WSJ:
"If you could set your tick size [minimum bid-ask spread] much wider, market participants will react," said Jeffrey Solomon, chief executive of banking firm Cowen and Co. LLC, speaking to lawmakers at the hearing Wednesday. "Investors like round numbers--nickels, dimes and quarters."
... Moving to broader pricing increments could be a boon to providers of equity research, which have been forced to focus on heavily traded, brand-name stocks after the move to pennies, according to Patrick Healy, Chief Executive of Issuer Advisory Group, a consultant to companies on exchange matters.
Brokerage firms often can't afford to spend money developing reports on thinly traded companies because firms are less likely to make back that money through commissions linked to trades in such securities, said Healy. With less research available on small-cap companies, mutual funds and other institutions may not be inclined to invest in such stocks, he said.
A higher tick size raises the cost for your average retail trader who crosses spreads to transact.  If you give the brokerage a greater franchise value, they will spend more on research fluff, but any mutual fund relying on these reports should be restricted to paper trading.

 If people really like round numbers, why not apply this to everything. I hate coins, and feel I give more to the take-a-penny-give-a-penny tray than most. No more $2.09 coffee at Starbucks, generating 91 cents of change.

 Of course, a firm wishing to increase its relative bad-ask spread it can always push its price down to below $10 via a split share, and some clearly do that.


 The chart above is taken from data over the past year, and shows a strong increase in the relative magnitude of the spread over the share price as the price goes below $15, so issuers can target this themselves. A Washington solution clearly would favor industry insiders, like Jefferey Solomon of Cowen and Co. LLC

Wednesday, June 20, 2012

The Fantastic Keynesian Endgame

I really dislike fawning Keynesians because I used to be one when I was a TA for Hyman Minsky back in college (he was a Post-Keynesian). As such I was enamored with Keynes, and read many biographies about him. There's no greater ire than that of early infatuations, in part because we feel tricked, and these objects remind us of a naive earlier self that wasted part of our precious finite life on a wrong road. Anyway, I can't can read the familiar Keynesian tropes (eg, 'Keynes wanted to save capitalism') without rolling my eyes.

 A good indicator of a failed vision is a fanciful endgame.  If that endgame is clearly wrong the vision is wrong.  Marxists and their ilk thought the rate of profit would continually fall, until the proletariate took over and the state withered away.  In the 1940's economists thought that while capitalism offered greater liberty, the higher productivity of socialism would overtake capitalism.  And then there's Keynes' famous 1930 essay The Economic Possibilities of our Grandchildren, in which he imagined that in 100 years or so, the greatest problem would be how to spend our leisure.  Note that Frank Knight, Ludwig von Mises, and Freiderich Hayek never considered this possibility, highlighting their more accurate understanding of human nature.

Anyway, the latest Keynesian thumbsucker to take on this essay is biographer Robert Skidelski and son:
The irony, however, is that now that we have at last achieved abundance, the habits bred into us by capitalism have left us incapable of enjoying it properly. The Devil, it seems, has claimed his reward... The point to keep in mind is that we know, prior to anything scientists or statisticians can tell us, that the unending pursuit of wealth is madness. The first defect is moral. The banking crisis has shown yet again that the present system relies on motives of greed and acquisitiveness, which are morally repugnant.
This pompous blowhard grew up part of Britain's upper class (he's a Baron, whatever that means), and watching one's status fall stings.  Now he wishes money, and the market skill generally associated with it, weren't so important for determining one's social status anymore (though it was fine when gramps made the family fortune that bought his peerage).

 He asserts that because Westerners got rich because we are intrinsically greedy, we now are rich but do not enjoy it because we are greedy: a Faustian bargain indeed! Yet, looking at hunter gatherers or hippies, both anti-materialists, I hardly see a more cultured, meaningful, or higher levels of existence.  Mark Zuckerberg, meanwhile, seems centered, nice, intelligent, and interesting.

 As per greed being repugnant, I don't see what is intrinsically wrong with greed if such people are not hurting me. Minding my business under the rubric of safety or fairness, in contrast, is a much more common sort of intrusion in my life, and extremely unwelcome. Greedy people who pay for themselves by creating things of great value to others are both more fun and virtuous than do-gooders who spend all day thinking about new ways to force other people to work for other people.  Of course, there's a lot of luck and skulduggery involved in any market economy too, but it's more fair than anything else I've seen.

Skidelski assumes that we should be egalitarians, and so, anyone wealthier than me hurts me via my now lower relative wealth, regardless of what he does with the wealth. That's not society's problem, that's his problem.

He imagines the standard Marxian utopia of people engaged in thoughtful, productive, artistic activities, and notes we don't seem geared that way right now:
The pleasures of urban populations have become mainly passive: seeing cinemas, watching football matches, listening to the radio, and so on. This results from the fact that their active energies are fully taken up with work; if they had more leisure, they would again enjoy pleasures in which they took an active part.
So, he advocates we all become artisans of some sort, making homebrew, tending gardens, writing poetry.  Yet he notes people like to relax by just watching a movie.  If they didn't have a job, would they then more actively partake in their leisure?  I doubt it.  As Henry Ford said, I can think of nothing less pleasurable than a life devoted to pleasure.

People get most of their pleasure, and meaning, being useful to others, which includes inspiring the admiration or happiness of others by one's actions. Every time I make my daughter squeal with delight makes me thankful to be alive, because I know she really loves me, and I work to provide her with things and habits that will make her prosper, and hope that at some point after I'm gone she will remember me with sincere gratitude. A healthy wage is a strong correlate with one's usefulness to non-family members, especially if you work in field without a lot of regulation.

Our valuations are not just internal, which is why in Robert Nozick's famous experience machine thought experiment where one is asked if they could spend their life in some sort of holodeck that offered incredible but fake experiences,  most people don't want the fantasy life. This is because living in a morphine high of solipsistic pleasure isn't estimable, but rather, pathetic. A satisfying life affects other people in a positive way, which is why those 'flow' advocates really don't understand what they are talking about--it's not the flow, its the feeling that one's focused actions are banking esteem in some communal credit bank, even if it is in some future world.   It's paradoxical that those focused on mandating altruism seem to think satisfaction can and should come purely from within.   

In contrast to the Keynesian vision of us all trying to figure out how to spend our endless vacation, there's Eric Hoffer, the enigmatic philosopher who appeared out of nowhere around 1934 in California at age 34, and claimed to be an autodidact longshoreman. I suspect he was a German immigrant who at one point was a rabbinical student, and wanted to avoid immigration restrictions so he made up some story about growing up in Brooklyn.  

Tom Bethell's recent biography of Hoffer notes   his vision of the future was prescient, not fanciful, highlighting a much greater profundity.  Hoffer himself didn't take much to make him happy: a well-written book to read, and evidence someone thought well of him.  He thought intellectuals found free societies a threat because such societies didn't need mandarins directing them, and if not flattered would help incite the masses to some sort of revolution.  A man is likely to mind his own business when it is worth minding, and so those unhappy with their own meaningless affairs will focus on minding other people's business. Hoffer noted one must not merely provide for those without meaning in their lives, but provide against them, because in a democracy and market economy their preferences will have power. Those who see their lives as inferior and wasted crave equality and fraternity more than they do freedom, and this can cause a Republic to fall to a democracy, and ultimately a tyranny.

In other words, Hoffer describes the essence of the Liberal desire to micromanage society into perfect equality at the expense of liberty. A coalition of intellectuals and the underclass, both of whom feel unappreciated.  We haven't figured out a good outlet for these do-gooders, or a good way for those without a purpose to find life rewarding, so they continue to plague us with their plans and angst. That's a realistic vision of society, a future problem that is real yet potentially soluble. 

Tuesday, June 19, 2012

Dark Pools: Good Book, Bad Title

Scott Patterson's new book Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System suggests a Rolling Stone type expose of vampire squids sucking the vital fluids out of widows and orphans. In contrast, most of the book was about the development of electronic exchanges from 1990 through 2007, especially focused on the firms Archapelego and Island. It reminds me of Justin Fox's Myth of the Rational Market which suggested a rather slanted and damning hatchet job but then did nothing of the sort. I suppose the marginal business book buyer is on the way to an Occupy rally.

 I work on tactics related to these tactics and technologies, so found it very enjoyable. The real hero of this book, rightly, is Joshua Levine, who started Island. He pioneered paying for flow, where one pays those making markets, and charges those crossing the spread. He was on the bleeding edge in cloud computing, creating more robust infrastructure with a fraction of the budget than his big-time competitors. I know people who dealt with him, and they highlight how thoughtful he was about sharing information back in the day on order strategies, technical stuff that others might guard in a paranoid fashion. Levine thought if his customers could make more money, they would trade more, and this would breed even more liquidity. In other words, a classic business mensch.

 There are lots of numbers thrown around, but it's good to remember that  electrons move about 1 foot per nanosecond, so there's a basic limit to how fast these things can get.  It is true that humans generally take  a couple hundred milliseconds to process information and push a button, so clearly computers that can turn around info in a couple milliseconds beat humans in any whack-a-mole game.  But all that pico-stuff is pretty silly.  Consider the S&P minis futures contracts trades 400k times a day, so every 60 milliseconds (thousandth of a second) represents the highest frequency relevant for any contract. Stocks like IBM trade about once a second. Thus, all that super speed below a millisecond is not for trading so much as 'lining the book', market makers playing games in the queue to provide liquidity.  Your average trader should think about this as much as they think about what's going on underground at Disney World.   

There's a theme that originally the innovators wanted to cut out the middlemen, but then discovered there were new middlemen. Meet the new boss, as The Who would say. The bottom line is that spreads on big stocks like MSFT and ORCL used to be ¼ in the good old days before ECNs, which allowed lots of traders to make a fortune via their monopoly access to customer flow and the various barriers to competitors. That these specialists are now unemployed should be considered classic creative destruction.  I knew several of them; they were lucky while it lasted, and it lasted too long.

 The book is a bit light on actual tactics, making some strategies sound a lot more effective than they are. For example, Patterson describes a strategy he calls "0+", that supposedly makes money with zero risk. In fact, this strategy does have risk, because it presumes that you can always exit your position before the queue behind disappears.   Often a level gets 'taken out' by an order and so the queue behind you is gone within any possible time to place new order and get out at scratch (pre-fees, I should add). Indeed, the trader plying this strategy is presented later pathetically fishing for 10 minute stock predictors like thousands of other punters, highlighting this was no money pump.

A lot of the conspiracy talk around algorithms presumes a market price reflects 'true value', like the mass of something, and that algorithms are keeping others from it. Market prices approximate value, but a price is really an aggregate compromise, one that almost everyone disagrees with.  If you want to buy more, now, you will pay a higher price because you need to convince more people to take the other side. Jehova shouldn't care because 'true value' is unaffected by such concerns, but the market does, and so comparing prices to some assumed point estimate of 'true value' just leads to meaningless disquisitions.  If you want to think about such issues just remember all those theologians who wrote about the 'just price' for about one thousand years and whose work is now totally ignored for good reason, to give you a sense of your futility.  

The bottom line is that those buyers and sellers with big orders have always moved markets from their 'last price', and in the old days this was all done via a coalition of partners over a phone, but now algorithms sniff out these orders by noting a higher-than-usual buy crossing rate, or sense a really big iceberg limit order, and so basically have expropriated the front-running revenue from the traditional recipient of this value. A large order will move prices so it's going to be exploited, and this is better done competitively via electronic markets than by a specialist with monopoly access to the flow.

 There's some funny other stuff in there, like how regulator are pretty irrelevant to all the innovations. Indeed, the regulators appear more interested in protecting the status quo, as George Stigler noted 50 years prior in his work on the industry capture of regulators. Mary Schapiro gets her standard uncritical mention, as she is always presented as the righteous regulator who would have prevented the 2008 crisis if it weren't for Lawrence Summers and his cabal. Her big idea after the flash crash was 'circuit breakers', aka limit price moves. This doesn't help much, as decades of experience with these in futures has shown, though it does 'work' if you merely want to prevent prices from moving more than 5% a day (why not solve the Greek budget deficit by not reporting it?).

The Flash Crash of May 6 2010 included an order to buy 75000 contracts when your average price level had only 5000 contracts there, so it pushed the 'market price' into uncharted territory. Its understandable these things happen, it's a new technology, lots of users, and lots of new emergent properties, most coming down to problems related to idiots placing large 'market orders' that wipe out several 'levels' of prices. I bet the exchanges will figure out a governor in spite of what the SEC does, but such issues are really irrelevant to what caused the crisis of 2008 or the 'Global Financial System.'

Part of a popular work on technical issues seems to involve building up the major players as geniuses, going over their rocket science background. In this case it's like pointing out how every professional football player was an outstanding high school athlete--financial innovators tend to have done well in math and science, so that whole physicist turned financier story isn't rare or intellectually sexy. I suppose that's how to get your hooks into the masses, because people like to read about geniuses.

In spite of the scary title, it's simply a good story of how innovators destroy the old guard. If you are worried about high frequency traders you almost surely trade too much, and would be better focused on asset markets built on things that are truly unsustainable.  High frequency traders are very sensitive to cash flow (note Trading Machines shut down pretty quickly after not finding a niche), so they aren't building palaces based on unrealistic expectations like, say, California or or NYU journalism majors.  

Sunday, June 17, 2012

Is Spitznagel an Apostate?

Mark Spitznagel, former employee of Nassim Taleb, has run the Universa Hedge fund for a while and seems to be doing quite well for himself (he bought Jennifer Lopez and Marc Anthony's old home in Bel Air). What his returns have been I don't know, but they are always reported second-hand when vol spikes (as usual regulation is the opposite of helpful here, discouraging hedge fund reporting that would allow investors to more accurately estimate returns for various strategies).

Anyway, Taleb's Black Swan investment advice seemed to be a barbell strategy with a lot of something really safe balanced by radical risky investments. Because people don't appreciate the magnitude or frequency of infrequent events, these low-probability but large impact events offer good returns. In this white paper, Austrians of a Feather, Spitznagel seems to be saying that doesn't work. He seems enamored by Austrian business cycle theory, and an unfortunate side effect of which is to abjure clarity and concision. Thus I'm not sure what he's trying to say, but it seems he is saying that tail risk, out-of-the-money options and their ilk, are fairly priced if not overpriced. The real market opportunity is in predicting specific Black Swans. In other words, speculating on rare events, as opposed to presuming rare events are under appreciated in general.

 Taleb is listed rather prominently on the Universa Website and Spitznagel graciously credits Taleb in the paper, but Taleb and/or Spitznagel have put a fork in the archetypal Black Swan theory (and yet, Taleb has never been really consistent, so one can say he meant this all along at some level). I have no doubt some people can predict infrequent events, and perhaps Spitznagel is one of them. Yet it's pretty hard to validate objectively, and in my experienced is best done via observing all the little good investments someone has made for 10 years, something that is impossible to do in scale. The idea that if you can predict infrequent events you can do very well for yourself is true enough, but that's a lot less useful to know than if rare events are unappreciated in general, which turns out not be be true.

Friday, June 15, 2012

Truth and Loyalty

Norman Finklestein, the go-to academic for the Jewish anti-Zionist take on Middle East events, was interviewed recently. I found this precious:
NF: Because Chomsky’s biggest virtue, you know what it is? Aside from his staggering intellect and absolute faithfulness, Professor Chomsky never betrayed a friend. He will defend them even though inside he knows that they’re completely wrong.
Q: But don’t those virtues of friendship and faithfulness come into conflict with the truth?
NF: I know that! I see that! But he cares very deeply about the facts. Let me tell you a story...
 Jonathan Haidt highlights that loyalty is an important virtue to conservatives that liberals tend to not value. That is, loyalty is seen by liberals as blind obedience, something peculiar to Authoritarian Personality types, an unalloyed vice. Yet that's in abstract. Loyalty is always prized at some level, even the liberal fringe like Chomsky and Finkelstein. Myrmecologist and sociobiologist E.O. Wilson argues that the essence of most of what is publicly esteemed as virtue relates to actions that help the group: patriotism, selfless giving, etc.

I have come to appreciate loyalty more, as like Haidt's liberal personality type, I used to think loyalty was simply not a virtue (that I don't fit the liberal archetype is besides the point). However, unlike Finkelstein I am under no illusion that loyalty is totally consistent with the truth, rather that there are trade-offs and sometimes a lie is worthwhile if it helps one in a relationship. All the virtues involve trade-offs as when one is too honest to be polite or too polite to be honest; moderation in all things. If you think you never lie then you are really self-deceived because as Michael Gazzaniga has demonstrated, our left, narrative, brain confabulates all the time when interpreting and reconciling data it receives from the right brain and peripherals.

Thursday, June 14, 2012

Beta Factor Proxy Portfolios

I just discovered some new long/short beta ETFs: BTAH and BTAL.  One goes long high beta, short low beta, equal dollar weighted, equal sector weighted; the other is the opposite.  That is, they both are 'factor mimicking' portfolios on  beta, one the inverse of the other.   They use the top 1000 stocks in the Dow Jones US index as their universe, and pick the extremum 200 as their holdings for longs and shorts.  They don't trade much (~20k shares per day), and they might have some technical issues trying to target the top 200 each month, but I wish them well.

As per sector neutrality, I think that's overkill, but I know lots of people like it.  That is, you miss a lot of the essence of the beta factor by neutralizing sector weightings.

If these existed for twenty years we wouldn't have any doubt about the shape of the Security Market Line.

Tuesday, June 12, 2012

Levered ETFs Highlights Volatility Demand

PowerShares rolled out a pair of ETNs offering inverse exposure to Japanese government bonds, the 3x Japanese Government Bond Futures ETN (JGBT), and the 3x Inverse Japanese Government Bond Futures ETN (JGBD). Government bonds are typically considered low risk, but to generate sufficient demand, it appears you need to lever them so they have high enough risk to warrant interest.  I suspect that in 10 years, everything will have a 2x and 3x derivative that's tradable on liquid exchanges.

Now, one reason for the demand is that accounts like 401ks discourage leverage, so the leverage is implicit in the ETF, and not explicit.  This is a big problem with leverage limits because leverage can always be gamed in this way, and there is no simple solution.

But I suspect the main reason is more fundamental: people like volatility, and so demand increases with higher volatility.  Now, in most formulations, risky asset demand is determined something like this.

First, maximize the weight on the risky asset, where w is a proportion of the investor's portfolio allocated to the risky asset:


By definition, the risky asset has a Gaussian distribution, and the risk-free asset is some constant.

Taking the derivative with respect to w and setting equal to zero gives us the familiar risky asset demand.

This says it is linearly related to the expected return, and inversely related to its variance.  Increasing leverage increases the return (numerator) by X, and the variance (denominator) by X2, so the ratio changes by 1/x.  Optimal demand, in this theory, goes down parri passu with the leverage; leverage should not affect actual $ demand because it washes out.

Yet, in practice that's not what happens.  I'm not sure what's going on, but I think part of it is a quantum effect, where investors are not interested in something until it can generate a sufficient threshold return.  That is, most investors basically have 'null' for their Japanese bond exposure.  A significant number of investors would put down $1000 if they had a chance to make $200, but many fewer are interested in putting down $1000 to make $100.  Sure, they could always lever positions themselves but that's another level of complication, creating all sorts of operational risk such as issues about taxation and margin calls.  

Monday, June 11, 2012

Poor Volatility Buyers

The VXX and TVIX target the VIX futures index, a metric of forward-looking volatility, and trade well over 40 million shares a day. As the VIX went up from 20 to 80 in 2008, which I guess makes a lot of people think this is a smart trade. With all the tumult this year, the VIX has remained about the same since the beginning of the year, but the VXX and TVIX are down 41% and 72%, respectively.

Since inception (Jan 2009), the VXX is down about 95%, and since Jan 2008, the SPVXSTR index (which matches the VXX pretty well) is down about 88%, so it's not like over time this strategy has a positive return. I bet a large fraction of these buyers have a copy of The Black Swan on their bookshelf.  The best way to play the volatility game is not to buy it, but to avoid relatively high volatility assets.  People overpay for stuff with large positive skew, like lotteries, and volatility.

Sunday, June 10, 2012

Banks Key to Recovery

With news of a possible bailout in Spain, bank bailouts are in the news again.  I'm a big believer that banks are key to this recovery, but I'm skeptical that bailouts are actually helpful.  That is, the best way to add a lack of focus to a bank is to make it even more beholden to 'the public'. A restructuring or default would be preferred, because then the pain is allocated to investors, and so new owners can start over without any baggage from prior favors from politicians and just maximize profits (there's a good reason to think this is what banks should be doing, but I understand many find that argument incomprehensible).

Anyway, I think one of my better ideas was in a post I wrote last year on Barrier Options and Business Cycles.  The basic idea there was that if you looked at banks as not an option on a firm like in a Merton model, but as a barrier option on a firm, the vega actually becomes negative when the firm value is sufficiently low.  This would mean banks go from taking on new projects to maximize equity value, to shedding projects.

Bank stocks are still well off their historical highs, and I think this has some relevance to our rather unusually soft recovery.

Monthly bank index data from Ken French's website

Friday, June 08, 2012

Meta Bias

in Cognitive Sophistication Does Not Attenuate the Bias Blind Spot just published in the Journal of Personality and Social Psychology, the authors note :
As opposed to the social emphasis in past work on the bias blind spot, we examined bias blind spots connected to some of the most well-known effects from the heuristics and biases literature: outcome bias, base-rate neglect, framing bias, conjunction fallacy, anchoring bias, and myside bias. We found that none of these bias blind spot effects displayed a negative correlation with measures of cognitive ability (SAT total, CRT) or with measures of thinking dispositions (need for cognition, actively open-minded thinking). If anything, the correlations went in the other direction...More intelligent people were not actually less biased—a finding that would have justified their displaying a larger bias blind spot.

I put this in with evidence that IQ is positively correlated with not just deception, but self-deception. This is why stupid sons don’t ruin a family, the clever ones do. Remember this the next time someone tells you their strategy is based on heuristics and biases, because it isn't obvious people aware of biases are less biased.

Hat tip: Robin Hanson

Monday, June 04, 2012

CAPM Never Confirmed?

I was looking at a 2004 JEP paper from Fama and French on the history of the CAPM.  Interestingly, they mention all the papers that showed the slope on CAPM betas was too low, and it included just about every important empirical paper on this subject.  It got me thinking: was there ever a paper that didn't estimate the security market line was 'too low?'

Recall that, in cross-section regressions, the Sharpe–Lintner model predicts that the intercept is the riskfree rate and the coefficient on beta is the expected market return in excess of the risk-free rate, E(RM) - Rf. The regressions consistently find that the intercept is greater than the average risk-free rate (typically proxied as the return on a one-month Treasury bill), and the coefficient on beta is less than the average excess market return (proxied as the average return on a portfolio of U.S. common stocks minus the Treasury bill rate). This is true in the early tests, such as Douglas (1968), Black, Jensen and Scholes (1972), Miller and Scholes (1972), Blume and Friend (1973), and Fama and MacBeth (1973), as well as in more recent cross-section regression tests, like Fama and French (1992).

The evidence that the relation between beta and average return is too flat is confirmed in time series tests, such as Friend and Blume (1970), Black, Jensen, and Scholes (1972), and Stambaugh (1982). The intercepts in time series regressions of excess asset returns on the excess market return are positive for assets with low betas and negative for assets with high betas.

When I was in grad school, this was not conventional wisdom, though with hindsight it supposedly was.  Rather, we emphasized that you could not reject the CAPM if you threw the kitchen sink of uncertainties and refinements in there. This kind of historical revisionism, common among stock prognosticators and consultants, is really misleading because it makes it seem that a bunch of really smart experts are never really wrong about something right in the middle of their bailiwick.