How to Get High Returns From High Volatility Stocks

Rebalance daily! Turan Bali, Nobel Prize winner Robert Engle and Yi Yang, posted Dynamic Conditional Beta is Alive and Well in the Cross-Section of Daily Stock Returns over at the SSRN. It's an eerily similar title to Jagannathan and Wang's 1994 pub The CAPM is Alive and Well, which supposedly showed the same thing.  When people have to continually state something is 'Alive and Well,' you can be pretty sure it is 'Dead or Dying.'

Such research confirms my thinking that prejudices are more important than statistics when analyzing complex data, because people tend see what they believe rather than vice versa. Thus, developing good prejudices is more important than developing good econometric skills, reminding one of Oscar Wilde's dictum that 'Education is an admirable thing, but is well to remember from time to time that nothing that is worth knowing can be taught.'

In any case, they state:

Average return and alpha differences between stocks in the lowest and highest conditional beta deciles are about 8% per annum, implying a profitable zero-cost portfolio that goes long stocks in the highest conditional beta decile and shorts stocks in the lowest conditional beta decile.

  If higher beta stocks did have higher returns, many investors would hold their nose at the volatility and accept the price for a higher return.  Yet, the risk and return are both lousy, so such a fund has never been popular.  Consider that the low vol ETF SPLV trades about 1 million shares a day, while the high beta ETF SPHB trades about  50k shares per day.  SPLV is up since inception in 5/11, while the SPHB is down  (see below, click to enlarge).

It's a short sample to be sure, but one can ask Robeco or Arcadian how their low volatility funds have done, among many real-world examples (eg, I wasn't sued because low volatility didn't produce positive alpha).  Indeed, a glaring datapoint against the assertion that higher beta implies a higher return is the absence of a popular, explicitly high market beta fund, precisely because such stocks have had horrible returns. Consider there have been value and size portfolios even though these have high value and size risk, because they have higher-than-average returns.  As mentioned, if higher beta truly gave one a return premium, desperate investors like CalPERS would gladly take on the risk.  

The authors spend a lot of time on various subtle refinements of beta, making sure they are super fresh and estimated with the much more sophisticated Maximum Likelihood method, as opposed to some simple matrix inversion. They correctly note that the CAPM, and any of its derivatives (the APT, the SDF), are conditional, and so theoretically you need to update your beta estimates constantly as conditions change.

I've played around with beta calculations enough to know there isn't any real edge to doing something really tricky. Sure, you can do better than using the past 9 months of daily data using an exponential lag by adding some trickier refinements, but not much. The 36-month betas ubiquitous in the literature generate qualitatively similar outcomes for everything I've looked at, so that's not the key problem with the CAPM, any more than using the equal or value-weighted indices (also irrelevant). Indeed, their own paper shows their four different betas generate the same positive return to beta (a 4% annualized spread), only more so (8% annualized) if you update in more frequently than once a year.  So, their refinement doubles a return advantage that practitioners don't see.

In any case, this is irrelevant. The key is that they are using daily returns. Now, daily returns are problematic ever since the first estimate of the size effect was found to be overstated by 15% (annually) due to daily rebalancing effects (see Blume and Stambaugh).  Using monthly return data, since 1962, I find beta negatively correlated with returns, excluding the bottom dregs of penny stocks that add spurious precision but are untradeable (basically, I took the current $500MM cut-off, and applied that backwards in real terms). The data is over at www.betaarbitrage.com.

It would have been better to instead correct for the daily rebalancing bias rather than all that beta refinement so reminiscent of the 1980's focus on ever more sophisticated tests that produced nothing of lasting importance to anyone but a tenure-seeking finance professors.

But hey, lots of people worry about crowding into the low-volatility space, so I'm happy that the old guard doesn't have to change their mind about this if they don't want to. As Max Planck said, science progresses one funeral at a time. It's a mug's game trying to swat down all these statistical refinements that theoretically could matter, but don't. Much better to actually trade an idea and see if it works.  Too bad about finance students, however, spending valuable time learning a beautiful theory that is 180 degrees wrong, all for $50k/year.

The Naivete of Moderates

My local paper had a sequence of articles by Stephen Young, who presented caricatures of the left and right.  On the left, the Nanny State that gives us unlimited welfare rights and asks for nothing in return.  On the right, social darwinism, which ignores public goods and is indifferent to racism and child slavery.  He's part of the Caux Round Table, a group that wants a 'free, fair, and prosperous global society built on the twin pillars of moral capitalism and responsible government.' It's part of a long tradition of orphaned policy wonks. 

By setting up two indefensible poles as the planks for our two major political parties, he then suggests that his moderate solution is not merely reasonable, but optimal. I could say his ill-defined middle path is just like that articulated in Venezuela, India, or even Nazi Germany, with all sorts of corporate cronyism shielded by the state's monopoly on 'moral competition.'  I'm sure Young would reply, 'that's not what I meant.'  Perhaps, but the main problem with most political plans is not the intent but the result. Further, it is no less a caricature than what he does to the left and right's positions on politics.

I empathize with a desire to find common ground, especially among those who really don't have strong opinions on socialism or free markets, yet their arguments are pretty weak.  I'd rather they just say they, "I'm indifferent, let's make a deal," without any pretense that such a solution is anything but a temporary compromise.

The Non-Linearity of Leadership Competence

One of the more profound facts of life is nonlinearity.  From radiation to vitamins to things like politeness and honesty, optimality lies in some middle ground.  You can have too much or too little, which is what makes life non-trivial, because you always have to find that middle optimal point yourself, often by trial and error.  The optimal organization for a family is communist, but this doesn't generalize to large societies, a point that most leftists can't fathom.

The latest example is Sandy Weill, Jamie Dimon's mentor, stating that Glass-Steagall may be a good way to constrain the too-big-too-fail.  This regulation was totally irrevelant to the housing crisis, and the regulation was already impractical when it was repealed.  There was no difference between those banks with large investment banking operations and those without in the recent crisis, and in the quiet 1935-2005 period Europe had nothing like Glass-Steagall without adverse consequence.  It's a red herring.  The key is simply the size of financial institutions, which at a certain level become politicized.  Eliminating Glass-Steagall would just prevent efficient economies of scope.

How could Weill be so clueless on something so fundamental?  He was a dealmaker.  His specialty was simply buying other companies.  His knowledge of how various regulations affect the macroeconomy, or how they affect a company's risk, is at the level of your average fortune 500 CEO: banal.

Leaders of small groups tend to be highly competent, able to do almost everything better than everyone in the group.  Yet for large groups, leaders are quite clueless.  I remember working for executives at KeyCorp, and the big joke was always how to dumb down things for our CEO and the management committee.  They were hopelessly clueless about the most basic relationships between interest rates and our basic business, or risk factors on our book.  Consider that Bob Rubin was on the management committee at CitiCorp, and after pulling in $115MM, noted that he had no idea they were exposed to the mortgage debacle.  I'm sure he was telling the truth.

Needless to say, the policies of Bill Clinton and George Bush were extremely important in the mortgage fiasco, and they too are so oblivious they rarely even bother to comment upon it.  They were merely for more home ownership, which given enough cognitive dissonance is totally unrelated to the eventual result that no money down mortgages were being given to people without income documentation.

In my experience, CEOs and politicians with tens of thousands of subjects are much less competent than leaders of organizations with 10 to 100 people.  The big leaders are very good at politics and public relations, necessary skills, but ones I personally don't find very interesting or admirable, mainly because platitudes and insincerity are so common in that realm.    

Economists Idea Bag Seems Empty

BigThink asked some great young economists about big ideas in economics. I'm not very sanguine about any of these guys finding something important very soon. It starts with Paul Krugman, lamenting that

the central cause of the profession’s failure was the desire for an all-encompassing, intellectually elegant approach that also gave economists a chance to show off their mathematical prowess.

Krugman got his Nobel Prize for a mathematically elegant model of international trade. There was no new, true and important insight of that model, it was merely an elegant rationalization of some stylized facts that has zero predictive power and is 99% orthogonal to anything he himself actually discusses about economics. I glad to see he sees the pointlessness of such parochial models. Will he give back his Nobel Prize?

 Here are some great insights or projected intellectual trends, from young star economists.

 NICHOLAS BLOOM:

people in developing countries are poor because wages are low, and wages are low because firms are very unproductive, and firms seem to be unproductive in large part because of bad management.

RAJ CHETTY:

[We need to] identify the determinants of intergenerational mobility, with an eye towards finding policies that increase equality of opportunity. Should we be focusing on increasing access to higher education? Changing the structure of elementary schooling? Revamping the tax code?

GAUTI EGGERTSSON:

[We will see] the study of traditional questions, such as how to use monetary and fiscal policy to eliminate unemployment and control inflation.

XAVIER GABAIX:

The modeling of agents with bounded rationality will help us build economic models (in particular, macroeconomic and financial models) and institutions that better take into account the limitations of human reason

GITA GOPINATH:

In an increasingly globalized world, the search for answers will necessarily require a much deeper understanding of three areas that interest me. One, we need a better understanding of the interlinkages across countries in trade, finance, and macroeconomic policy.

I stopped, but it continues in this way. If BigThink asked me, I would say:

I see a big payback to integrating psychology, anthropology, and history into economics more directly, using real-world data to understand how prices, output, and inequality relate to institutions, norms, education, and taxes. And vice versa.

Of course I'm being a bit snide because I find these answers as vapid and trite as any politician's platitudes.

Primate Status Battles

Robert Sapolsky's book Why Zebra's Don't Get Ulcers focuses on how stress increases serum glucocorticoids (eg, cortisol) and these lead to higher mortality from many dimensions, but primarily arterial sclerosis. He did original work examining baboon troops and found glucocorticoid levels inversely correlated with status, mainly because when you are low status you are often randomly slapped by a higher ranking baboon venting frustration, or have your hard earned meals swiped.

Interestingly, if you are navigating a baboon hierarchy, it actually is good therapy to take out a recent slight by smacking some random lower ranking baboon, as he measured their stress levels before and after (Sapolsky notes that, with some exceptions, he doesn't really like baboons; they're mean). Further, another thing that raises stress is fighting for position in the hierarchy, so when a new alpha male comes into the troop and everyone has to compete again for position, this is stressful. Think of a baboon leadership change as a recession, in that the creative destruction from new leadership may help the troop in the long run, but in the short run everyone feels worse.

This stress-hormone-mortality connection has a direct analogue in humans, as evidenced by the famous Whitehall study, which did a lengthy longitudinal study and found that a British civil servant's level was inversely correlated with mortality rates, primarily from stress-related arterial sclerosis.

Yet, Sapolsky's explanation of why status matters to humans is rather weak. He argues that, like low status baboons, poor Americans are physically hungry, and pushed around by their betters (eg, no bathroom breaks for factor workers). In fact, the lowest SES individuals are both fatter and commit more assaults than those in higher socioeconomic status levels. Stress isn’t mainly caused by objective insults, but rather subjective ones, primarily feeling under appreciated. This is highlighted by Sapolsky's own work, which noted that human subjects glucocorticoid levels increased when faced with stressful social evaluations, not when faced with merely difficult logic puzzles. He can't escape his Marxist instincts and goes for dialectical materialism, where the structure of production implies classes, alienation, and angst.  I see it more like in Aaron Beck's cognitive therapy, where dysfunctional thinking, behavior, and emotional responses lead to lower income and poor appreciation from others in general.

If you like science and lean libertarian as I do, you have to get used to gratuitous asides about how inequality or ignorance is merely a choice of an indifferent society, and that obviously if we wanted to, we could spend more on the poor and look just like Sweden. After spending trillions of dollars on Third World aid, and on the War on Poverty here in America, this is clearly not true. Americans have not chosen more inequality out of indifference to the poor, rather, it's an emergent response to our naive attempts to directly rectify these inequalities: SES indicators of all sorts stopped improving right around the time welfare and civil rights started exploding in the 1960s.

It is somewhat sad to think that so many humans suffer angst thinking about things like mortgage payments or how our children will fare, while Zebras are pretty stress-free as long as lions or dominant males are not messing with them.  Thus, they don't get ulcers because if the stressor isn't right in front of them, it isn't there.  It gets back to Socrates' question as to whether you would prefer being a happy pig or an unhappy human.  Surely, once you've take the blue pill you can't go back, but it's not obvious to me that many unhappy humans would have had a better life as a happy pig.

Prop 13 Isn't Choking California

My brother is a standard progressive liberal living in California, and he plans to move to Oregon soon. As California is run by Liberal principles, in large part, I asked him why California is so poorly managed. His answer: prop 13. But he's not a lunatic, Nobel prize winning economist Paul Krugman has made the same argument.

 Prop 13 was a state law enacted in 1978 that prevented property taxes from rising much as long as you owned the property. When you sell it, it resets. While the hope was this would help little old ladies from getting pushed out of their houses, and keep government spending in check, the net result is that with inflation you now have many places where people are living in million dollar homes and paying taxes as if it were only a $100 home. Looking at it differently, they are spending 10x as much as their neighbor on taxes.

 This would fit the narrative that bad things happen mainly because people don't care enough to spend government money on them. That point was made yesterday by the writer John Scalzi, who claimed he owed his success to government in this piece, and noted:

From kindergarten through the eighth grade, I had a public school education, which at the time in California was very good, because the cuts that would come to education through the good graces of Proposition 13 had not yet trickled down to affect me.

But then, per capita spending in California on schooling is higher than anywhere else in the US (see here), and per capita spending has been above inflation plus population growth for the past 20 years (see here). Californians still pay 22% of their income in state and local taxes, compared to 14% for Texas (cite). The beast is not starved. I agree that prop 13 is a rather ham-handed way to implement constraints on spending, and now it's a mess because it creates a very powerful lock-in effect on current property owners. But it has little to do with California's downward spiral, a state that used to be the most educated, prosperous, and beautiful place on the planet, is now near the bottom of state achievement, and their public places (airports, beach bathrooms) are poorly maintained, like the bankrupt state they are.

Some Quant Screwed Up

Last Thursday, a very non-typical hourly saw-tooth pattern emerged in several stocks. By the time we saw this mid-day, we were intrigued, with some message boards noting it. I don't know the provenance of this pattern, but suspect it was a poorly designed algorithm that was trying to buy some fixed amount at the hour until completion, and did this repetitively over the day in some newfangled VWAP attempt. It looks like it shot out stupid buy orders for the first 30 minutes of each hour.

Clearly someone screwed up, because after the second time this happens you should stop your stupid program and tweak it.

Here's IBM, Coca-Cola, and McDonald's price movements over that day. This isn't random.

IBM

Coca-Cola

McDonald's

James Watson on Modern Marxists

In this interview, James Watson comments on those opposed to genetically modified food. He makes this observation on how Marxism got aligned with environmentalism:

And then, you know, the usual leftist, Marxist, communists who, when they can't fight for communism, became environmentalists, because, you know, as an environmentalist the chief evil was the rapacious corporation, which is going to destroy the air, the soil, the oceans, etc. So it was, you know, Marxists need bogey enemies.

I think one good way to divide the left and right as commonly understood are those who fear power concentrated in government versus those who fear power concentrated in corporations. He's a pretty funny guy. When asked if he would want to live forever, he says:

You mean, stay at 50? Uh, I'd freeze women at 35 ... Right now I haven't met a 100 year old person I want to look at.

Low Vol Momentum

So, I was in Boston talking about low volatility to a couple of groups. I met a couple of current practitioners and it is very interesting to hear about the different approaches these guys take. They tend to have very different takes on what is going on, and what investors really care about, and these subtle differences lead to very different portfolios if you are talking about choosing 100 stocks out of 2000 possible.

 More cynically, each firm selling these approaches needs to differentiate itself, because simply trying to be better than a competitor is risky: there's at least a 50% chance of failure, and possibly higher because it might degrade into a simple price war that leads to no prices (Bertrand competition). There's no need to be so cynical here because everyone comes to low vol from such a different approach (eg, flat or negative Security Market Line?).

 At my Qwafafew talk (during which, I quaffed a few--beer and finance are complements), there was a true believer in the audience defending the conventional wisdom, which was actually quite refreshing. I like actually engaging with them because they generally don't argue with me, adopting the debating tactic of hoping an embarrassing criticism will go away if you ignore it. They have been doing that to me for years. Anyway, he insisted that beta was positively correlated with average returns, you merely had to measure beta correctly. I can't prove it can't be done, but I haven't seen it, and I'm pretty certain any journal would publish such a result asap, so I'm skeptical.

I'm even more skeptical because when I asked him if he would agree that beta is positively correlated with total variance, he said, 'not necessarily!' as if this was some great gotcha point. Correlations refer to statistical relationships, meaning, there are some datapoints off the linear relationship. Clearly, some stocks will have high variance and low beta or vice versa, but all discussions about risk and return are about averages and tendencies; the distinction about there being exceptions to financial generalizations is not like saying there are exceptions to gravity. I thought he was really reaching if that's the kind of counterargument to my assertion that risk and return aren't correlated in general.

 He did bring up the point that I tended to put up data on geometric averages, and that arithmetic averages would generally be more consistent with the theory because the arithmetic returns are greater than their geometric averages by a variance term. That's a valid point, but only geometric averages uniquely correspond to total period returns, and so the geometric average is to my mind a better statistic of a portfolio's performance. Further, this is why the scope of my findings are so important: across many asset classes, the average returns are generally flat. Average returns are unbiased estimates of future total returns, but then sometimes one should see massive outperformance by these high volatility portfolios, which we do not. It's a complicated issue, and I can't treat it sufficiently in this point, but I should mention that while I think this is one of the best arguments by the risk-begets-return crowd, it still fails empirically.

 Then there's the issue of overcrowding that always seems to come up. I find this rather amusing, because when I was trying to sell this idea in the 1990's, before anyone thought it would work, a common argument was that 'what if everyone did it?' It's like when you show someone something that has worked well for 50 years, and they say, 'sure, but now it can't work because I'm sure everyone sees it.' Well, if everyone invests by maximizing Sharpe ratios, then we are in the CAPM world that creates the positive sloping security market line, but we've been telling MBAs to do this for decades to no avail. Considering all the money in value and small cap funds, I don't think the modest allocation to low volatility has changed things.

 In fact, there are two good pieces of research put out on this point recently. One by Pim van Vliet at Robeco (download here) documents a metric of value for low vol portfolios back to 1930. He finds low vol has gotten more expensive over the past 5 years, but looking at it in context it is not so scary (it has been here before). Nevertheless, he argues this is why you need his secret sauce. Self serving, but rightfully so. Another (here), by quants at Deutsche Bank, found that low vol is not overcrowded primarily using pairwise correlation data. That's an interesting way to view crowding.

 One thing I found interesting is that in institutional asset management, finance and econ PhDs are common. That's quite different than in my day-to-day field where physics and computer science PhDs are more common, where we aren't interested in soliciting client money. I'm on the fence as to whether this means financial theory is useful for investing large amounts of assets in broad asset classes...or that it merely is more helpful in selling one's services to institutions.

I'm Speaking Tuesday in Boston

I'm speaking Tuesday the 17th at 6 pm at the Quantitative Work Alliance for Applied Finance, Education, and Wisdom (aka QWAFAFEW, really). It's at the Tennis & Racquet Club, 939 Boylston Street. Walk-ins are accepted, space permitting, but see here for info to see if that's feasible. I have a new book coming out soon, The Missing Risk Premium: Why Low Volatility Investing Works, which I estimate will be available in a month, and will have an inexpensive paperback and an e-book version.

It's Useful to Actually Plan

Charles' Murray's Losing Ground was that most incentives in life are negative, in that if you don't do X you will starve or freeze or whatever. Thus, you learn to be thrifty, nice, and hard working to simply get by. The most common complaint by businesses as to why they fail is that their  banker stopped lending or seized their collateral; if they just had more time things would have turned around.

 Promising large pensions is one of those things that keeps increasing future liabilities, and if you simply plan based on cash flow--including borrowing--you will hit your constraint with probability=1. Bankruptcy seems to be the only realistic constraint.

 Here's a now bankrupt city mayor explaining a minor lacunae in her management style:

Stockton Mayor Ann Johnston voted for these expensive measures when she served on the city council. 'We didn't have projections into the future what the costs might be…I learned that you don't make decisions without looking into the future'… 'Nobody gave thought to how it was eventually going to be paid for,' says Mr. Deis, the city manager.

Who knew?

How do the 1% Win in a Democracy?

The 99% seem to be pathetic at asserting their self interest. They have a huge majority, but are totally incompetent or unwilling to assert their preferences. What's the matter with Kansas? Here's a simple theory, where I will assume there's pretty much a 50-50 split currently among the electorate as to the preferred direction for tax rates, regulation, etc. Those who succeed in the marketplace favor allocation by markets, not governments. Those who do not succeed in markets favor government.

Now, people tend to get happiness not so much about what they currently consume, but rather an expected consumption of the future. Robert Sapolsky has some neat data on monkeys and finds that monkeys and humans commonly generate the highest levels of dopamine when pleasure is anticipated, not when pleasure is actually experienced. See the graph above for a picture of how dopamine spikes upward not when the monkey gets the reward, but rather when it anticipates getting the reward; the actual reward is anticlimactic.

 So, having the highest present value, not current value or one-time gimmick, is what drives people's political regime preferences. A person's preference for more government over less would involve whether one's relative competence is greater in the private or public sphere. Increasing government through more taxes and regulation is good for those with a comparative advantage in politics, not good for those good in the private sector. If the economy contains only the private sector and government, this means increasing marginal tax rates is only good for those who are relatively good at government.

 This rationalizes the Bryan Caplan puzzle that people tend to not merely vote for the direct self-interest of their income level, but are rather 'groupish', or altruistic towards their group whatever it may be (humanity for some, a tribe for most). In the long run moving to a larger or smaller relative private sector affects one's future with a different sign depending on one's 'skills'.

 Every month or so I get a letter from some class action lawsuit that gives me $2 if I fill it out, all for some vague corporate crime. Such class action suits aren't interesting to me because  they are not worth my hourly wage and more importantly they don't raise my status, rather redistribute money from some unknown corporate exec to some unknown lawyer plus everyone.  Similarly, bonking all the George Soroses on the head, taking their money, and giving to all Americans would be pretty pointless: it wouldn't raise the relative status of anyone other than the chief prosecutor. If I think this money won't merely be redistributed, but rather, reallocated towards a different sector, I have to ask myself: which sector do I want to see succeed? An increase in tax rates or government benefits implies a relatively larger governmental sector.

 Diversity consultants, union reps, etc., want the size of government to grow because it helps their status; those good a solving problems for a profit maximizers would relatively lose, and prefer the opposite. This is why the issue of tax rates is usually a toss-up even though, from a simple perspective given the lognormal distribution of wealth this seems counter-productive. Those good at markets want the non-governmental sector to thrive, even if that means the superstars become billionaires. It's not anticipating a higher income for everyone via trickle down economics, it's anticipating higher status for them as their preferred sector grows.

 Everyone, no matter how incompetent, has a comparative advantage. Half of us have a comparative advantage in the private sector and so want it to succeed, relatively.

Obviously, it's more complicated than that, but as a 30k foot view, I think it explains why so many making below $250k/year don't want taxes raised on those with such incomes.

Happy Independence Day!

Vacation: g-forces, water ... weddings!

CFPB Not Doing Anything

A Wall Street Journal article notes that the supposedly independent Consumer Financial Protection Bureau has had many meetings with the Executive branch (ie, Obama). They are spending $340MM this year, with only 1000 employees. Research and development, I guess. I really hope Obama wins so we can see this agency flourish, because only conspicuous failure changes things.

Our Green Government

When you don't have a bottom line, rather a mish-mash of objectives, massive inefficiencies can be tolerated. Here's a bit on our new green navy:

The USNS Henry J. Kaiser carried nearly 900,000 gallons of biofuel blended with petroleum to power the cruisers, destroyers and fighter jets of what the Navy has taken to calling the "Great Green Fleet," the first carrier strike group to be powered largely by alternative fuels...Some Republican lawmakers have seized on the fuel's $26-a-gallon price, compared to $3.60 for conventional fuel.

In addition to the rather large extra expense we have an increase in crony capitalism, those bureaucrats from both sides of the aisle will be cashing in:

The Pentagon paid Solazyme Inc $8.5 million in 2009 for 20,055 gallons of biofuel based on algae oil, or $424 a gallon. Solazyme's strategic advisers, according to its website, include T.J. Glauthier, who served on Obama's White House Transition team and dealt with energy issues, but also former CIA director R. James Woolsey, a conservative national security official.

The bigger the size and scope of government, the more of such winners, who then pay for candidates who continue their subsidies, why we have had a quota on sugar imports since 1934. But I'm sure the Keynesians will note that a dollar spent by government otherwise would have been destroyed via private thrift, so it's all good.