Who is the Father of Low Volatility Investing?

Any good idea is found independently, and there are always early works that seem to unambiguously imply the ultimate result even if they never really focused on it. So it is with low volatility investing.

Bob Haugen has been touting unconventional investment tactics for decades, starting with The Incredible January Effect published in 1987. Alas, the January effect was one of those anomalies centered on low-priced, small-sized, firms, that usually don't scale well. Do you remember the 'low price' effect? It was popular in the 1980s, along with the size effect, as small size and low priced stocks were highly correlated and both seemed correlated with very high returns. The low price funds are now something anyone associated with them at the time conveniently forgets, because trading them is very costly, like trading options instead of stocks.

Anyway, I saw him being interviewed at a Dutch conference, with the talk 'The Low Volatility Anomaly' on the screen, where he was arguing investors should move their equity exposures to low volatility oriented equity funds. At one point the interviewer asks if 'will you be known as one of the big heroes of the twenty first century?' In sum, I would say he was the first to publish on this, but he didn't know what he found, so the importance of his early work only appears with hindsight, or to those who took his facts and ignored his interpretation and emphasis.

Haugen did publish a very prescient piece in 1975, Risk and the Rate of Return on Financial Assets, that clearly empirically addressed the basis of the CAPM, and found beta was not related to returns as expected. He even states 'we find little support for the notion that risk premiums have, in fact, manifested themselves in realized rates of return.' Right on! Unfortunately, I think the issues then were on methodologies for simultaneously estimating betas and expected returns, so this was not very highly cited, and Haugen, like the rest of the profession, turned to highlighting factors that seemed to explain expected returns irrespective of risk (eg, calendar effects, value). The testing of the CAPM was left to the econometricians, with work by people like Gibbons, Shanken, and Ross.

In 1996, Haugen again argued that low-risk stocks tend to outperform high-risk stocks. But the emphasis on this paper was this was a consequence of market inefficiency. He created a model with many factors, grouped into 1) risk (eg, beta, volatility, 2) liquidity (eg, volume, price), 3) value (eg, P/E), 4) growth potential (eg,ROA), 5) past returns (eg,past 6-month return), and lastly 6) sector variables. Each class had ten or so highly correlated metrics within them. A more recent paper he did (again, with co-author Nardin Baker), basically applied the same idea. He noted the highest returning portfolio constructed via this backfitting were of lower volatility and beta than the lower returning portfolios, but that was incidental.

The emphasis was clearly on a model that predicted returns, and even now he touts 70 factors, many of which are highly correlated. The factor risk premia are calculated on a rolling basis, so signs on these factors bounce around. It's a classic kitchen sink regression. I don't see the emphasis as being 'low volatility', rather, that is a characteristic of his 'highest expected return' portfolios, which is his focus. For example, his 1996 Journal of Portfolio Management article on this riff was titled 'The Effects of Intrigue, Liquidity, Imprecision, and Bias on the Cross-Section of Expected Returns.' Lately he discusses three types of volatility--event-driven, error-driven, and price-driven--which he tries to separate and use differently. I think he's slicing this too thin, as you get pretty similar results using total or idiosyncratic volatility. That's a lot going on, but clearly volatility and risk are not emphasized as prime movers, he just found that risk was inversely correlated with these more interesting factors.

I do think he's a bit disingenuous with his performance. His page showing the cumulative returns for his various models shows a rather incredible upward growth since 1999. However, I remember some using his factors in the latter half of 2003, and the model generated a significant draw down, well-outside the scope of his backtests. Interestingly, there's no evidence of that in his charts. I presume that was an earlier version that got dropped down the memory hole.

In sum, I think he didn't prioritize volatility until the low-volatility movement get really going to get credit for 'low volatility' investing per se. While I wrote my dissertation on this back in 1994, but it went over like the Hindenburg with academia, and I never got refereed publication on the volatility result, so I wouldn't say I'm a founding father (I didn't have an equilibrium story then, and this was before Freakonomics and the popularity of behavioral finance, so back then it just didn't make sense). I would say that the two main academic pieces I relied upon for my finding then were Bruce Lehman's 1990 Residual Risk Revisited, and Ed Miller's 1977 Risk, Uncertainty, and Divergence of Opinion. Both focused on volatility, and implicitly noted that there appeared an attractive investment strategy implied by the poor average returns to highly volatile stocks. Indeed, in 2001, Miller mentions this strategy in the Journal of Portfolio Management. It seems, one needs a theory to see something, and because Miller had this theory (winner's curse) he had thought relevant to equities, he saw the investing implication before others. That is, one could deduce it as a corollary of Fama and French's 1992 finding that beta was uncorrelated with average returns, but as Fama and French merely extended the standard model to other risks, they missed the low-volatility/beta bandwagon. For example, Haugen's big theory had been that markets are inefficient, and so I think he wasn't focused on volatility for the reason that this insight is incomplete: inefficient in what way?

By the mid aughts, several academics had discovered this in various guises. There's Analytic Investor's Clarke, de Silva, and Thorley (2006) and Robeco's Blitz and van Vliet (2007), which focused on low volatility portfolios. Then there's Ang, Hodrick, Xing and Zhang (2006) highlighting the poor cross-sectional returns to higher volatility stocks, and that really was seminal for academics. Firms like Analytic Investors, Robeco, Arcadian, and Unigestion all started low volatility funds around this time, so they had all seen this years earlier. Indeed, many of these guys read Haugen and Baker (1991), which documented this first, but again, Haugen inferred something different from this and went on a return-factor hunt. While all this was becoming common knowledge, I was fighting a lawsuit by a former employer trying to stop me from using volatility as an investment factor, and I remember thinking how crazy it was that I had to fight to use something I had been touting since 1993 that then had a pretty large publication thread.

Quantitative Easing Tough on Pensions

From the WSJ:

While quantitative easing boosts the value of pension assets, it lowers investment returns and increases estimates of future liabilities. Because typical defined-benefit plans are only 70% funded and face liabilities several years longer than their assets, that leads to wider deficits...But many trustees say the best response would be for the BOE to stop buying long-dated gilts and buy bank bonds instead. Not only would this ease bank funding difficulties, and thereby improve the supply of business loans, it would allow gilt yields to rise.

With interest rates at historic lows, pension funds are in a tough spot. If interest rates rise, they will suffer capital losses and actually be in a tougher spot. I'd say this is good reason to avoid bonds that are attached to entities with large, unfunded pensions (eg, states, munis).

When the government tries to improve prices, it creates winners and losers.

IMF Chief Economists Blames Problems on Investors

Olivier Blanchard is a very well-respected academic economist, and currently also Chief Economist at the International Monetary Fund. He sees today's current big problems primarily due to investors.

• Self-fulfilling outcomes of pessimism or optimism, with major macroeconomic implications.
• Incomplete or partial policy measures can make things worse.
• Financial investors are schizophrenic about fiscal consolidation and growth.
• Perception molds reality.

So, the unsustainability of Euro member fiscal policy is supposedly irrelevant, compared to the insane, self-fullfilling prophesies of investors. As John Cochrane noted, the Euro leaders keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology.

Regulators Don't Help

One of the reasons why I'm a libertarian comes from my experience with financial regulators. They are totally out of their depth, not understanding where risk really lies because the essential information simply can't be grasped by flying in and looking and talking to people for 2 weeks. I have never worked in a financial firm where I felt I understood what was really going on for at least a couple years. They fill out reports conceived by someone ten years ago that would have caught last decade's big error, and come back next year. The good ones, and there are many, realize the futility, but it's a paycheck.

Anyway, now here's the European regulators repeating the mortgage fiasco. Remember pre 2007 regulators encouraged mortgage lending without qualification. Now, the issue is Greek debt. John Cochrane nail it:

Indebted governments have been pressuring banks to buy more debt, not less. As banks have been increasing capital, they have loaded up even more on “risk-free” sovereign debt, which they can use as collateral for ECB loans. The big ECB “liquidity operation” that took place yesterday will give banks hundreds of billions of euros to increase their sovereign bets...So much for the faith that regulation will keep banks safe....They keep looking for the Big Announcement that will soothe markets into rolling over another few hundred billion euros of debt. Alas, the problem is reality, not psychology

Banks Lend, Charge, Too Much

The suit against BAC/Countrywide was based on disparate impact, basically looking at averages for Blacks and Latinos vs. EveryoneElse. Presumably they controlled for some kind of credit metric too, but as Thomas Sowell has noted many times, it is common to run a regression looking for discrimination with an incomplete proxy for education like whether they had a degree, then put in a dummy variable for race, and find discrimination by looking at the loading on the race dummy, even though given the lower socio-economic status of minorities the variable omits a lot of other important variables (eg, what kind of school? what kind of degree?).

The key point is as follows:

In 2007, for example, Countrywide employees charged Hispanic applicants in Los Angeles an average of $545 more in fees for a $200,000 loan than they charged non-Hispanic white applicants with similar credit histories. Independent brokers processing applications for a Countrywide loan charged Hispanics $1,195 more, the department said.

So, they were charging the victims too much. But another narrative of the 2008 crisis is that they foisted loans upon people who couldn't afford to pay them back. Isn't price the key way a supplier rations goods to consumers? As Jesse Van Tol of the National Community Reinvestment Coalition (NCRC) argues: "the major contributing factor to the foreclosures crisis was reckless and irresponsible lending.” By this, I presume he thinks banks lent too much. In 1994 Obama was party to a class-action lawsuit alleging banks rejected too many minorities.

Back in the bubble, I'm sure a lot of borrowers were less worried about closing costs because many builders, non-profits, and even our government's own HUD would bundle those into a loan. The borrower then has a costless call option: if prices rose--as they had for the past 10 years--they would win big, if prices fell they could walk away and leave the bank with the property. Mortgages are non-recourse, banks can't take anything more than your mortgage back. Thus, I don't see the overpaying minorities as victims here so much as greedy dupes who were part of the mortgage fiasco.

So, banks lent too much at too high a price, when not lending enough. These are simply inconsistent allegations, highlighting the no-win situation for bank lenders. With such rules, no wonder political insiders like Peter Orszag, Henry Cisneros, and Bob Rubin are essential banking executive talent.

True Value Weak Guide

I remember seeing an update of investment bank analysts, and they separated their ability into two groups: those good at predicting earnings, and those good at predicting stock prices. There wasn't much overlap. So I found a spreadsheet from a colleague's thesis that looked at the Pound/dollar exchange rate from 1973-2005, and noted while there was a pretty boring pattern in purchasing power parity ratio, but the market's value of the pound against the dollar fluttered around it quite a bit. It seems that if for some reason you were the only person in the world who knew the inflation rates in these two countries, your investment strategy would only be marginally attractive.

Keynesians Believe in Markets Too

Paul Krugman argues that the fact that interest rates are currently low in the US proves his standard Keynesian diagnosis is correct. Here he is in the NYTimes arguing again why the fiscal and monetary stimulus dials should be turned to 11:

Early on in this crisis I and quite a few other economists — but not enough! — declared that we had entered a classic liquidity trap ... even large government borrowing won’t drive up interest rates, and you can print as much money as you like without causing inflation...[non-Keynesians] declared that soaring inflation was just around the corner, and that interest rates would spike...

So how’s it going? Interest rates have, of course, remained very low. As I post this, the real interest rate on 10-year bonds is actually negative.

He sounds like a caricature of an efficient markets theorist. Well, Markit's A-tranche for the all their vintage mortgages traded above 99 cents on the dollar at the end of 2006. By the end of 2007 they were around 45 cents, and today they all trade around 7 cents.

I remember GM being a zombie for years and their stock defied my expectations for a decade, but eventually equity owners were zeroed out and they went bankrupt. You can go a long time with negative profits if people are willing to give you credit. Yet as any small business lender knows, the only thing that stops these institutions is a lack of cash. Currently, US debt is so liquid, and has such a strong history, it remains a top credit. Yet it's good to remember that when I was in charge of economic risk capital allocations back in the 1990s for bank, mortgages had the lowest economic risk rating for any non-sovereign debt. Now it is on par with credit cards (ie, the worst credits).

I don't think this is going to end well for US debtholders, but time will tell. I don't expect Krugman to ever say he was wrong regardless given he called for a housing bubble in 2002 to stimulate the economy, and later explained that was an economic analysis, not a policy statement, as if that makes a difference.

Willpower for the 99%

The 99% is a story that fits many journalist's favorite narratives about the major problem today: inequality. This seems like altruism, but focusing on the top 1% is also consistent with envy. Many think the top 1% are responsible for the poverty of the 99%, especially the truly poor, those in the bottom quartile. Yet the poor are pretty far removed from anything the top 1% can do. Graduate from high school, get married before you have children, work at any kind of job, even one that starts out paying the minimum wage. Fewer than 10 percent of families that follow his blueprint live in poverty, while 79 percent of those who don't follow the three-step plan end up poor. There is no redistribution scheme imaginable close to this in reducing poverty.

A good Christmas gift for the poor would be Roy Baumeister and John Tierney's Willpower, a great little book with timeless advice. It notes that Willpower has an effect on life outcomes as great as IQ, and more importantly, is much more amenable to nurture as opposed to nature. Perseverence, discipline, patience, all take practice, and make you a happier, healthier, and more productive person. The basic premise comes from the Stanford marshmallow experiment, where a group of four-year-old children were given one marshmallow, but promised two on condition that he or she wait twenty minutes, before eating the first marshmallow. Some children were able to wait the twenty minutes, and some were unable to wait. The children able to delay gratification were tested in later adolescence and found to be psychologically better adjusted, more dependable persons, and had higher SAT scores. Given hardly anything is predictive at that age, this is quite remarkable.

Baumeister has spent much of his career as a psychologists studying and designing tests on willpower. He notes it is a finite resource, and so quitting smoking is much harder when you are also studying (the rigorous study of common sense!). But willpower is like a muscle in that it weakens while you use it, but also strengthens the more you use it, so practicing it daily by doing things like standing up straight and not swearing transfers to other areas. Making decisions is exhausting, it depletes one's willpower, so its useful to design simple rules for much of your daily toil. Being low on energy from lack of sleep or nutrition also hurts your willpower. Basically, practice daily acts of self-control to become more productive.

This reminded me of a Eric Kandel's work on brain memories. He won a Nobel prize by looking at snails and finding that long-term memory, unlike short-term memory, involved the synthesis of new proteins. You get long-term memories through repetition in the same way you build muscle through exercise, so if you practice something daily and it becomes a habit--the muscle memory of a golf swing, the neural memory of saying 'please' and 'thank you'--you actually have altered your brain. Your habits are not just abstract character, but have a biological substrate. This surely encourages cryogenics fans who want to freeze their dead heads in vats of liquid nitrogen so that they can be re-animated in the future.

Life is a journey from ignorance and instinct to higher virtues, including the prudence needed in a complex world. Such prudence comes mainly from acting with thoughtful resoluteness towards the many petty people and temptations around us. Willpower is a great book that reaffirms the power within us to become better people.

The 1 Percent

From Sports Illustrated, discussing the kick return phenom Patrick Peterson, who ran back a 99-yard kick to beat the Rams in overtime:

Peterson, 21, had also ignored instructions. In his case it was an order to not field the ball inside his own 10-yard line. He apologized to Spencer several days later. The two had a long talk, and Spencer informed Peterson that average players need rules. Special players need guidelines. Peterson now has guidelines.

Physical vs. Emotional Trauma

The issue seems to be we remember the emotionally traumatic events more than the physical. From When hurt will not heal, by Chen et al:

The present study examined an important distinction between social and physical pain: Individuals can relive and reexperience social pain more easily and more intensely than physical pain. Studies 1 and 2 showed that people reported higher levels of pain after reliving a past socially painful event than after reliving a past physically painful event. Studies 3 and 4 found, in addition, that people performed worse on cognitively demanding tasks after they relived social rather than physical pain.

Aaron Brown's New Risk Book

I got a copy of Aaron Brown's latest book Red-Blooded Risk, which is kind of like My Life as a Quant by Derman, in that's it's a very personal account of how finance works. I think it's very useful for 50-somethings to write retrospectives like this, because otherwise it's written by people too far removed or too naive. For example Michael Lewis's Liar's Poker is now a classic, but he was a mere bond salesman for 3 years; while his anecdotes were interesting and well-told, his big take-aways on how finance fits with the modern society and the economy were as naive as your typical 25-year old bond salesman.

Brown makes several important points. For example,he notes that the 99% value-at-risk might capture more relevant data, but it needs so much data one should look at 95% value-at-risks. While you can derive this from statistics, it is a practitioner point that clearly is better appreciated from experience. He clearly comes across as someone who understands both the math and how it is applied.

The book tries to deal with how to manage risk, mainly from the point of view of a hedge fund, or something where one is looking at a bunch of strategies. That is, in my experience as a risk manager at KeyCorp, most of our risk there was incidental as a market maker with customer flow, and such risks were rather trivial once one had 'rogue trader' risks under control. His view is more like if you are looking at a book with pairs traders, a momentum trade on government debt, and other such strategies.

Brown mentions early on that he is thinking about risk differently than the standard model, where risk is a cost, and return a benefit. He never really boils it down to something concrete, but rather over the course of the book tries to argue about his view of risk that is qualitatively different. It's kind of like trying to present the meaning of life, not with an aphorism, but rather a bunch of examples. On one hand, this can get you closer to the truth, on the other hand readers can come away confused.

As any professional realizes, however, the gestalt nature of 'risk' limned in this book is the way risk feels to most people--something important and hard to pin down, like meaning and justice--and so Brown's experience is illuminating and should save people a lot of time rediscovering these insights themselves (better to learn via a book than trial-and-error). I'm very sympathetic to the idea that standard risk models are misleading.

Brown's book is very opinionated and has the feel of a smart guy looking at lots of real situations. I think for big ideas, such as risk, meaning, and justice, it's good to have strong beliefs weakly held. That is, you only learn in these ambiguous domains by taking stands, trying to defend them, learning from the process and adjusting your prior prejudices.

It's a cliche to say risk management is the combination of art and science. You need to know something about history, statistics, and programming to be useful as a risk manager. You also need common sense, and that is best informed by experience, which is greatly abetted by reading insider memoirs like this.

Private Sector Incentives

A Northwestern grad student (just like I used to be) blogs on academic papers over at A Fine Theorem, and I was struck by this snippet:

The benefit of capitalism can’t have much to do with profit incentives per se, since (almost) every employee of a modern firm is a not an owner, and hence is incentivized to work hard only by her labor contract. A government agency could conceivably use precisely the same set of contracts and get precisely the same outcome as the private firm (the principle-agent problem is identical in the two cases).

This is wrong. I've worked in small and large firms, and in either case, being part of any initiative that makes money increases your pay and stature rather clearly. Now, the bigger the firm, the more people involved in any initiative, and the more people will exaggerate their involvement with successful projects and downplay their involvement in losers. But the bottom line is the bottom line, and the best way to get your boss to appreciate you more is to help him make more money for the firm. The scope of your command is rarely specified in detail, though increases in scope are the most obvious ways of increasing your power when the 'contract' comes up for renegotiation: work is a repeated game. The government principle has a very different objective function than the private firm principle, the former with a diverse set of stakeholders to satisfy, often with vague and inconsistent objectives, the latter to simply make more profits.

It's true that some people, especially those in over their heads, who are overpaid, dislike productive and smart direct reports because they sense their boss will recognize an attractive replacement. Yet even here the incentive clearly exists for this bad boss to be replaced by his boss, because his boss is not optimizing this position in that case (and watching the bad bosses employees leave when they recognize this is a really good signal that their boss is not a good one). It's also true that salaried employees like cashiers and secretaries may not be proactive about increasing their stature within the firm and simply follow orders, but their bosses recognize this and so are less likely to increase their responsibility.Every ambitious worker tries to make more with less all the time, because they can quantify this, which is the best way to go into an annual performance review. Just because you do not have shares in the firm does not mean you aren't highly incented to make money for shareholders, because the shareholder desire for more profits truly trickles down.

If this kid doesn't appreciate this, he's missing a big part of what makes private organizations work as they do. The nice thing is that it isn't a really fragile result like some of these theoretical models based on the types of agents and some envelope theorem. Common sense tells you the more you appear to be creating profits, the better your future will be in the firm and the industry, and the best way to appear to create profits is to actually do so. Economics, as Tom Sargent notes, is 'organized common sense.' Unfortunately, while you can formalize and thus teach models, you can't formalize and teach common sense, which is why game theory is so ambiguous on these important matters.

Investing Rule

I was on the Chicago Tribune website, and the top banner ad contained the following picture links to a site promoting penny stocks. The link went to a site with those annoying pop-up ads that are difficult to destroy. I think a good investing rule, or at least guideline, is to not buy stocks promoted at websites with half-naked women. Another might be to avoid investments that present +1000% returns as examples (see here or here), which are often common on these sites. As mentioned, average penny stock returns are pretty dismal, the ultimate lottery stocks.

Business Cycles and Barrier Options

I was at an NBER conference in early 2008 when we really didn’t know if we were in a recession, and Markus Brunnermeier explained to a group of esteemed economists that while the housing collapse was real, it represented only a couple hundred billion dollars, and by then the stock market seemed to have lost three times that, which seemed an overreaction, a sign of excessive volatility due to behavioral biases. This was not a contrary stance, rather, the conventional expert opinion. This turned out to be the tip of the iceberg, as the fundamental anomaly just continued. From a destruction in value of a couple trillion dollars in home values ultimately, the global economy lost around 60-80 trillion in value. No one knows how such small losses amplify in size and scope to create economy-wide downturns, because we have no good theory for it.

Banking expert Gary Gorton noted the strange metastasis of economic downturns:

But, when the crisis came, there was no distinction between pre‐ and post‐2006 vintages. Everything went down in value, including bonds linked to the earlier subprime vintages! Moreover, bonds completely unrelated to subprime risk, like triple‐A bonds linked to credit card receivables, auto loans – everything went down in value! [Hedge fund maven John] Paulson was right in targeting subprime, and he got the timing right. But, like everyone else, he got the magnitude of the crisis wrong. The tidal wave was much, much bigger than anyone expected.

That is, in the crisis everything lost more value than anticipated, the amplification or accelerator mechanism was underappreciated. Savvy investors may have predicted the housing debacle, but no one thought this would generalize this to autos, commercial real estate, everything, even though these market prices fell as well. This error was not because they were stupid, but rather we do not have any good model for how this works.

Here is my theory on business cycles. First, the impulse of the downturn I presented in my post on Batesian Mimicry. One could also count explicit tight interest rates as a cause, in that both would adversely affect banks. Here's my new idea, how a small loss transmogrifies into an economy-wide collapse:

Merton first created an option model to describe the value of a stock, which is really a call option on the assets of a firm. A firm’s debt is its 'strike price.' That is, owners of stock get all the upside, but if the firm loses all its value, the owners lose only their equity, the rest of the loss is born by debtowners. The average stock is levered 50%, so in general, stocks are options on the value of the firm. When I was at Moody's we were active in modeling public firm default rates using the Merton approach, where using the value of the stock (aka the 'call option'), the value of the debt (the strike price), and the volatility of the stock, you can back out an estimate the probability of default.

Interestingly, recovery values on defaulted debt tend to be well below the amount of total debt, about 50% on average. That is, if lenders could seize assets immediately, once the asset value of the firm hit the value of the debt (99% of par), the lenders would take over with minimal loss of principal. In practice debt holders are able to sieze the firm only after the firm’s value is well below its strike price.

This implies there is an 'absorbing barrier'. The absorbing barrier on companies is that firm value where debt owners force the firm into bankruptcy. A company can live forever, but at some point debtholders stop the clock, declare 'game over', and cut their losses. Thus stocks are not just call options, but barrier call options (specifically, down-and-out calls). Good models of down-and-out-options weren’t available prior to the late 1990’s (see Haug and Zheng).

Vega is the change in option value given a change in volatility. Positive vega means the option value increases with an increase in volatility, and regular puts and calls always have positive vega: more volatility increases their value. For a regular option vega is always positive, peaking at the strike price (when it is at-the-money). To make this clear, consider the bank owners (ie, equity owners), are managing the option value, and so the vega corresponds to its directive to take more risk.

Now, when banks are suffering due to some exogenous shock created by Batesian mimicry, the depositors become worried. Bank liabilities are generally shorter than their assets, where depositors have an option to call them back at any time. A bank run is statistically unlikely in normal times, but if people think the bank may be insolvent (ie, assets less than liabilities), they will rush to take out their deposits prior to anyone else, creating a self-fulfilling prophesy, so that the effective absorbing after a big decline in some parochial sector leads investors to wonder if their bank was overexposed to this sector. Quarterly balance sheets do not indicate the region, industry, and seniority, and underwriting behind, various assets, so when investors see a conspicuous asset decline they are rationally wary, as invariably some lenders will have been too concentrated in the affected sector. Thus, depositors become skittish, raising the barrier of a firm, because if depositors so much as smell a risk, they will create a run, killing the firm (eg, Bear Stearns).

The vega becomes negative when the barrier rises because now if a bank loses value, its option premium, its equity value, is extinguished. In a standard option, volatility is unambiguously a good thing, but with the barrier threatening its existence, the derivative switches sign at some point, changing the game entirely. Here, the value of the option becomes zero forever at 90, so the vega is zero there and below. Another way vega can switch signs is if the barrier is a certain level, and the asset value falls below a certain level, vega becomes negative. See below for how the vega changes as the asset value (ie, L+A) falls, for a special barrier value.

This vega switching is the unappreciated key to the transmission mechanism. To repeat: barrier call options, where there is a down-and-out option, switch to negative vega as the barrier rises, or for specific barrier levels when the asset value falls. This is unlike regular call options where the vega is always positive.

It also creates a positive feedback loop, because if banks are in this negative vega regime, they are not incented to buy any risky asset such as a failing bank. This means banks aren't able to buy other banks, effectively raising their absorbing barriers because no one is there to salvage their (non-barrier) option value. Regulators pile on, becoming more insistent on enforcing regulatory standards in order to safeguard banks, again creating a more tangible barrier above the strike (debt) price.

In a negative vega regime, banks add value by reducing risk, not increasing it. They all flee to safe assets, trying to replace risky assets with less risky ones, and avoiding the absorbing barrier. In bad times, banks have negative vega, they don't want more risky assets, and a failing bank adds a lot of risk (especially legal, as Bank of America is finding with their purchase of CountryWide).

A shock to banks causes creates a negative vega, which causes them to cut risk by cutting new lending and instead buy Treasuries (which causes interest rates to fall). This negative vega creation could be due to barriers increasing due to potential bank runs, or from vega becoming negative as the asset value falls (which holds for certain barrier levels). That may seem like a lot of steps, but consider the Krebs cycle has 8 steps, and it's ubiquitous and natural.

The implication is that the key to recoveries is pushing banks back into their positive vega position, so they again have an incentive to make risky loans. Currently, there are several outstanding class-action suits, and a suit by the Department of Justice, that could wipe the banks out. Many liberal economists are indignant that government money was used to rescue the banking sector and suggest that banks be forced to write down all their underwater mortgages as a payback to the public. Thus, even though profitability is rather high, bank asset values are still very low because they discount this possibility, and so depositors are wary, keeping banks in the negative vega region.

In contrast, the tech bubble of 2001 had a fairly limited effect on banks because most of the value destruction was in the equity, private capital. Thus banks were quickly back in the positive vega zone and the recession was pretty small. In contrast, bank stocks today are still well below prior highs. Below is a graph of the drawdown from the prior peak for the bank stock index, as generated via Ken French's data. The past peak is a high-water mark, so it tops out at zero, but in recessions falls (IndexValue/Max(prior Index values)-1). The current drawdown is comparable to that in the Great Depression, and notice it is still at historic lows (data is through October 2011).

This is why need strong banks, 'rich banks', as my old mentor Hyman Minsky used to say. Without them, financing collapses, and the economy stagnates. Only banks, with their many professionals evaluating idiosyncratic criteria with the sole objective of making money, can create the investment needed for economic growth. One can generalize ‘banks’ to any lender, which faces similar incentives and constraints. The best thing to do would be to stop threatening bank solvency with unlimited liability. All this focus on government stimulus and zero interest rates while simultaneously trying to punish banks for the past recession is guaranteed to not help because we need banks back in positive vega mode.

Bloggingheads to Downsize

Robert Wright announced today that he is scaling down his Bloggingheads.tv site, in part because as a business it clearly has no potential to make money. The basic problem, he found, was that his site tried to have people on both sides talk about issues, as opposed to what is much more popular, having people who agree with each other talk to each other (MSNBC, CNN, Fox):



Too bad, because I'm a big fan. It's rational to listen more to people you agree with because you think what they saying is more correct than others, so I don't find this a bad faith equilibrium. But on the other side, I do like listening to those I disagree with more on the radio drive time because invariably the host, and especially the callers, will come up with a horrible argument for their side. I much more enjoy listening to this when my intellectual adversaries are speaking than when someone says something stupid as an argument for something I agree with. That is, many (most?) people I agree with on taxes, abortion, affirmative action, war, etc., agree with me for reasons I don't think are correct or relevant.

Unsophisticated Investors Circa 2005

From the LA Times back in 2005:

"If you paid your mortgage off, it means you probably did not manage your funds efficiently over the years," said David Lereah, chief economist of the National Association of Realtors and author of "Are You Missing the Real Estate Boom?" "It's as if you had 500,000 dollar bills stuffed in your mattress."

He called it "very unsophisticated."

Anthony Hsieh, chief executive of LendingTree Loans, an Internet-based mortgage company, used a more disparaging term. "If you own your own home free and clear, people will often refer to you as a fool. All that money sitting there, doing nothing."

The financial services industry is doing all it can to avoid letting consumers be foolish. Ditech.com touts home loans as a way to pay off credit cards, and Morgan Stanley says they're a good way to fund education expenses. Wells Fargo suggests taking a chunk out of your house to finance "a dream wedding."

Nothing like spending your market value capital gains on fancy weddings. When people say that we should return to common sense, the problem is, how do we know what that is? (presumably this is code-speak for everyone should now agree with my hindsight diagnosis and cure).

Nationalize the Fed!

Paul Krugman's wife, Robin Wells, came out with a piece arguing Occupy Wall Street's issues are something economists should address. I wonder whether she thinks biologists should all teach about creationism because so many students believe in some sort of transcendental spark to life. Probably not. I do think there should be classes on free markets vs. Keynesian debates led by different professors, because it's not like this issue isn't always there, but I don't think OWS has made this any more pressing.

That is, in graduate school we never had any formal presentations by professors as to why Keynesians/Supply Siders are right, even though eventually this is the question everyone wants to know from macroeconomists. It was as if they thought they could be above such practical questions, and focus like Tom Sargent on technical issues. This is naive, avoiding the elephant in the room. Such debates or presentations wouldn't generate nice problem sets, and they would often be talking past each other, but it would be good to get this in front of the 24 year-olds so they don't have to figure it out themselves reading between the lines. Further, it would highlight to the presenters what kinds of questions they need to answer, what sort of arguments are most compelling, to thoughtful young people who at that point just want to pick a side they think is winning.

I find the Occupy Wall Street movement profoundly pre-adolescent, like when my 4 year old daughter throws a tantrum with inconsistent or impossible demands (indeed, Miley Cyrus has a video supporting them). For example, they generally are proud of not having explicit objectives, being grass-roots and all, and so fundamentally do not understand that decisions will never, can never, reflect everyone's preferences. Some souls did create a wiki of beliefs, that are the best we can address of this movement, which includes things like 'balance' and 'protecting human rights' . It's easy to want such things, and such rights were in the Soviet Union's 1936 Constitution just after committing genocide against the Ukrainians and right before finishing off the remaining Kulaks (alas rights conflict, and you always have priorities). They act as if Rousseau's social will exists, that everyone shares some trans-human soul with a preference towards drum circles and organic legumes.

I got a kick out of these items from the OWS set of demands:

Transitioning the IMF and World Bank into transparent, publically owned and operated entities

Ending the Federal Reserve Bank and replacing it with an accountable, decentralized, transparent and publically owned financial system

These institutions were created by democratic governments, populated primarily by those on the left (my friends who went this route were all conventional Liberals). That they are considered insufficiently transparent and unaccountable highlights that reality never creates the social vision they seek, which is some sort of transparent consensus on matters of incredible technicality. You see the same thing with Noam Chomsky, were socialism always is to be encouraged, but any time it happens, as in the Soviet Union, the Eastern Bloc, or Cambodia, these aren't considered 'true' socialist countries (if only Trotsky won!). Their naive beliefs do not work because they aren't feasible, and so too the idea that large banks can be some big cookie jar for agreed-upon investments as opposed to being administered by professionals.

Overconfidence vs. Optimism

In 1971 Robert L. Trivers gave us the idea of reciprocal altruism, the idea that helping someone else although incurring some cost for this act, could have evolved since it increases the chance that such niceness might be returned some day. This really expanded the conception of self-interest to be semantically indistinguishable from altruism in many cases. Biologists have observed this behavior in bats, where they share blood harvested, but only with those who share with them.

Trivers has some great anecdotes in his new book The Folly of Fools: The Logic of Deceit and Self-Deception in Human Life. In one, people's pictures are distorted to make people better and worse looking than they really are, using data on what 'good looking faces' look like. Looking at fMRI data, we actually recognize ourselves in pictures faster when we are about 20% better looking than we really are (they had models that generated statistically validated better and worse refinements to pictures). In other words, we really think we look better than we actually do.

In another study, children were told not to look in a box that contained intriguing toys while a researcher left them alone. Most of the children did look, of course, and most lied about it. Interestingly, the higher the IQ of the child, the more often they lied.

In this TED video, Trivers argues that we continually paint a distorted picture of the world so that we might more easily get our way with others. This involves constantly inflating our acheivements and abilities, and playing down our failings and rationalizing our mistakes. You are a better liar to others if you first lie to yourself. Lying to others and ourselves is evolutionarily selected for the same way that pale skin is selected for in northern latitudes. [The video is better than the book. He has many riffs on his Chomskian view of the world. I don't mind so much, remembering that Isaac Newton was a grade-A looney]

This is important for asset pricing because highly risky assets within any asset class often have lower-than-average returns, and Edward Miller (1977), Diether, Malloy and Scherbina (2002), and Baker, Bradley and Wurgler (2011) argue that overconfidence--and short sale constraints--lead to poor return for highly volatile stocks. We know people are overconfident, where most of us think we are better drivers, leaders, etc., and one prominent mechanism is that the higher the volatility of the stocks, the greater the disagreement, the more these miscalibrated optimists overbuy, which pushes down stock returns. Thus, understanding why people are overconfident is important.

Overconfidence is puzzling in many dimensions of our lives, not just financial. Intellectually, it lacks the knowledge and honesty that comes with wisdom, where one recognizes we are neither as good as our mothers think, nor as bad as our enemies think. Thus, I've always been a little perplexed by the idea that people find confidence so sexually attractive. Confidence is something I was lacking as a young man, and generally I would need several beers to initiate various courting rituals. While I understood that confidence was sexy, something I wanted to be, I couldn't fake it because I couldn't understand why something was both ignorant and desirable.

Looking back, I had it all wrong, but it my defense, it flustered good people like Woody Allen and Allen Brooks too. Girls don't like overconfident boys merely because they miscalibrated. The key is the nature of one's overconfidence. People who are confident about the future continue trying, even when it's hard. They assume the good faith of others, which makes for good first impressions. People like optimists because they tend to be less defensive, less easy to offend, and so easier to be around. Optimism is related to positive reframing and a tendency to accept the situation's reality, because optimists see the silver lining to problems. Optimists are copers, and pessimists defeatists. It is not confidence in specifics, but in the future, their future, that makes people attractive, and this is a rational disposition. A confident person need not be miscalibrated, though they often are, but rather, their confidence is really simple optimistism about their life in general.

Thus, our instinct to be overconfident is a salutary disposition, suitably framed. We should see the future brightly because if we simply do the best we can things will work out as well as they can. To the extent things are out of our control and work against us, it doesn't help us to worry about such matters. Insecurity on the other hand leads to pettiness, which is why we find such characteristics so unappealing (eg, insecurity led Anakin Skywalker to The Dark Side, and presumably more genocides than 100 Hitlers--he blew up an entire planet to make an example!). Like any virtues optimism and confidence are useful only in thoughtful moderation, in the right context.

Eurozone Causing Greek AIDS

A Greek economist notes that some Greeks are intentionally infecting themselves with HIV to qualify for benefits, the result of the Greek austerity forced on it by those nasty surplus countries currently funding their deficits. He mentions this, he says, to make dry statistics more real, to convey the true picture of what is going on in Greece. I see this as another reason why anecdotes are usually tendentious crap. Here he is on Bloggingheads.tv:

Greece can either 1) leave the Euro and inflate their way out of their internal obligations, 2) stop running a deficit or 3) do what their lenders say to get their money. Who in their right mind would lend them money given their track record?

Characteristics vs. Factors

the Low Volatility ETF LVOL, put out by Russell-Axioma, tries to capture the low volatility goodness via a circuitous route. First, it takes into account beta, and momentum in some unspecified way, which makes it a really hard thing to nail down. What most amused me, was that it calculates the return to the lowest volatility third of the Russel1000 index. It then selects a portfolio of about 100 stocks that track this index. The idea is that you find the target portfolio, and then, instead of using that portfolio, you use stocks correlated with it.

Downloading their current holdings, the equal weighted beta is 0.91--low, but not by much. The average 90-day volatility of their holdings is 39%. In contrast, the SPLV low volatility ETF simply takes the 100 stocks from the S&P500 with the lowest volatility over the past 12 months. It has an average beta of 0.6, and an average volatility of 28%. The Russel 1000 itself has a 90-day of vol of 50%, and a beta slightly above 1. In short the SPLV ETF delivers 'low vol' more simply, and more efficiently, by focusing on the characteristic, not the factor.

The idea that there exist risk premiums based on covariances with unidentified stochastic discount factors that are like the S&P500 return, but orthogonal to it, will be in the trash heap of bad ideas. As no one can articulate what such a factor might be, it seems absurd that millions of people are implicitly valuing companies, currencies, and futures this way. But a more tangible problem created by this theory is thinking that to get a certain return stream you should target the asset with the requisite factor mimicking beta, as LVOL has done.

Daniel and Titman documented that it was the characteristic, rather than the factor, that generated the value and size effects. They did an ingenious study in that they took all the small stocks, and then separated them into those stocks that were correlated with the statistical size factor Fama and French constructed, and those that weren’t. That is, of all the small stocks, some were merely small, and weren’t correlated with the size factor of Fama-French, and the same is true for some high book-to-market stocks.

Remember, in risk it is only the covariance of a stock to some factor that counts. Daniel and Titman found that the pure characteristic of being small, or having a high book-to-market ratio, was sufficient to generate the return anomaly, independent of their loading on the factor proxy. In the APT or SDF, the covariance in the return with something is what makes it risky. In practice, it is the mere characteristic that generates the return lift.

Davis, Fama and French shot back that their approach did work better on the early, smaller sample, and more survivorship biased 1933-to-1960 period, but that implies at best that size and value seem the essence of characteristics, not factors, over the more recent and better documented 1963-to-2000 period. Data in favor of Daniel and Titman's characteristics approach was found in France by Souad Ajili, and in Japan by Daniel, Titman and Wei.

In a similar vein, Todd Houge and Tim Loughran (2006) find mutual funds with the highest loadings on the value factor reported no return premium over the same 1975-to-2002 period, even though the value factor generated a 6.2 percent average annual return over the same period. Loading on the factor, per se, did not generate a return premium.

The standard equity groupings of size, value/growth, and now volatility, are best done directly, and not via an exposure to factor-mimicking portfolios.