Tuesday, November 14, 2017

Pension Actuaries: The Joke is On Us

...An Actuary is someone who wanted to be an accountant but didn't have the personality for it....An introverted actuary stares at his own feet, and extroverted one stares at the other person's feet....What is the difference between God and an actuary?  God doesn't think he is an actuary...."Look at the white horses over there." Actuary: "They're white on this side, anyway."

Unfortunately, when it comes to the mess our pensions are in, actuaries are no joke. Pension funds labor under actuarial assumption for expected returns that are mainly pulled out of thin air without any regard for financial economics. Does anyone really think pensions will be able to grow at seven percent or more per annum? When they are constrained by their various constituents to hold 50% to 60% in bonds and cash? (See Figure 3 of this OECD publication.)

Those unrealistic assumptions lead to unsupportable levels of contributions, and thus pensions are underfunded as a matter of course. You know the assumption are wrong when virtually every pension is on the negative side of the ledger.  But the actuaries do not seem to have been trained in the concept of making course corrections. Nor do they educate themselves in financial economics to better evaluate the mess they are creating.

Why am I going into this? Over the weekend I attended an event honoring a former colleague of mine from my days at Morgan Stanley, Jeremy Gold.  He is an actuary who has spent his career trying to move the pension actuaries toward a firmer foundation in financial economics -- to have them at least avail themselves of what financial economists can provide. In the mid-1980's, Jeremy and I worked together in the Fixed Income Research Group at Morgan Stanley. He and I went on various trips to push fixed income products, and to market the fledging new strategy of portfolio insurance (flying out once to have dinner with the head of the Port Authority of Los Angeles, who we discovered, part way through the first course, had -- surprise -- thought we were selling port insurance). We co-authored a paper in 1988, In Search of the Liability Asset, that is still on various reading lists, maybe not for actuaries, but at least for those in finance.

Jeremy left Morgan Stanley in the late 1980's to get a Ph.D. from Wharton, and spent the next twenty years as a thorn in the side of the actuarial profession, pushing them to add financial and economic structure to their methods. One of the best and most widely read of his works for this is the paper Reinventing Pension Actuarial Science.

At the base of it, finance is not actuarial science.  It is not predicated on repeatable, or even known, probabilities. There is no appeal to the law of large numbers for the systematic risks of the financial system.The future does not look like the past. There are no mortality tables for asset returns.

...What do actuaries and Packer fans have in common? They both think that history will repeat itself...

So if you want to be the arbiter for over 20 trillion of U.S. pension assets, a good start is to do it based upon a foundation in finance.


Monday, November 13, 2017

More on ETFs -- A Little Craziness in High Yield Bond ETFs

I wrote a post a month or so ago on the risks from ETFs, in particular how ETFs on less liquid markets -- with high yield bonds being my poster child -- could cause problems for the market generally.  Basically that there is a fundamental flaw when people think an instrument based on a illiquid market is capable of intraday liquidity. And that if the ETFs in such a market have a severe problem, ETFs generally might be considered tainted by a range of retail investors, leading to an outflow from even the more liquid ETFs.

Here is an article that points toward the potential for problems with high yield bond ETFs:
Investors Playing ETF Rout Pushed Junk Bonds to Brink of Chaos. 

Excerpt:

Trading in exchange-traded funds got a little crazy last week when it became clear that junk bonds were in for more pain. But the market was fortunate the consequences weren’t more severe, strategists warn. Though spared the worst, investors came close to creating a scenario where ETF activity drove prices....a snowball effect where a dislocation develops between the fund price and the value of its underlying assets.

Saturday, November 4, 2017

Our Low Risk (Low Volatility) World

In case you haven't noticed -- and I haven't -- we apparently are in a world of exceptionally low risk. To see this you need look no further than the volatility of the major markets. The volatility of the U.S. equity market, for one, is at its lowest level in a generation. So, no worries here, right?

I wrote a blog post in 2011 titled The Volatility Paradox which explained that when volatility is low, risk is actually rising because people are more emboldened to take on higher leverage and to move to riskier assets. If volatility is half of what it used to be, why not lever twice as much? Thus the immediate question is what happens if there is a sudden surge in volatility from our current, low level. What is the dynamic through which a volatility shock might propagate across the financial system?

A conventional stress test will assess positions that have explicit volatility exposure, such as positions in options, in the VIX and other volatility-based instruments. There is plenty of dry powder here; over the course of 2017, as the U.S. equity market volatility as measured by the VIX index dropped to one of its lowest points in history, we have seen a growing concentration in short volatility exposure by leveraged ETFs, mutual funds, and hedge funds.

But a stress test that does the simple mathematical calculation of direct portfolio exposure to volatility will underestimate the effect of a rise in volatility, because there are dynamics triggered by other strategies that do not have explicit volatility exposure but that have a link to the volatility of assets and to the assets themselves. A rise in volatility will trigger actions for these strategies, leading to selling of the underlying assets, and this in turn will lead volatility to rise even more, creating a positive feedback between the volatility of the market and the assets in the market.

What are these strategies? Well, a good place to start are volatility targeting, risk parity, and other strategies that will rebalance their portfolios when volatility rises. Volatility targeting is a strategy that targets a level of volatility to manage risk that is typically set based on the manager’s mandate. For example, the manager might follow a strategy that will seek to keep the portfolio’s volatility near 12%. If the volatility of the market is 12%, the fund can be fully invested. However, if the volatility of the market rises to 24%, the fund will sell half of its holdings in order to stay in line with its 12% target. Risk parity allocates portfolio weights to have the same total dollar volatility in each asset class. These multi-asset class strategies often use leverage to adjust holdings of underlying assets, buying more of the lower volatility assets relative to the higher volatility ones. If the volatility of one of the asset classes rises, the fund will need to sell some of that asset class in order to maintain equal dollar volatility. In both of these cases, there is a clear mechanism going from the rise in volatility to a drop in the underlying asset.

Things won't all happen at once. The agents for these strategies differ significantly in their time horizon. Those who are directly linked to volatility, those that are in short-volatility ETFs and the like, will have an immediate P&L effect from a surge in volatility, and will need to reduce their positions immediately. The volatility targeters will only reduce positions as the rise in volatility is seen as having a non-transient component, and their adjustments will be in a weekly to monthly time scale.  And the risk parity agents will have an even longer time horizon, because they generally make asset adjustment with a monthly or quarterly time frame, and do readjustments based on a longer-term estimate of volatility.

Oh, a little more on the relationship between low volatility and risk: If you want to see really low volatility, look back at the swaps markets in the summer of 1998. But you might recall that in August of 1998 there was a rash of defaults in Russia, which was then followed by the blow up of LTCM, the (before that) famously successful quant fund whose principals a few months earlier had graced the cover of Business Week (never a good sign). In that case, low volatility didn't spell low perceptions of risk, it was an indication that no one wanted to go into those markets because things were so uncertain. I go through my first-hand experiences with this in one of the chapters of my 2007 book, A Demon of Our Own Design.

Thursday, November 2, 2017

Interview in the U.K. for the Daily Mail

I had a video interview in the U.K. on my recent book, The End of Theory, with Rachel Straus, (Big Money Questions), that just came out with the Daily Mail. You can get to it here.

Monday, October 30, 2017

The Vanishing Pavilions: The Gutting of the Government and the Loss of Oral Tradition

What will be the longest-term damage of the Trump era? A strong, principled leader will restore some semblance of decency and ethics. Foreign governments might view this period as a bad dream, or an outlier event that veered the U.S. away from a now-returning normal. The anti-scientfiic and pro-industry biases in the various departments and agencies can be rectified just as quickly as they were enacted.

There has been plenty of discussion of where the long-term damage might be on the world stage; the new path governments and businesses are taking toward China -- this might have been inevitable, and Trump has been nothing more than an accelerant; the move toward center stage of China and Germany as world leaders.

But within the U.S. the long-term damage will be more subtle. It will be the loss of the oral tradition, of institutional memory, in our government. That is, the loss of processes and interactions that are conveyed by word of mouth and by example as opposed to by written instructions.

The U.S. Treasury is a case in point. I worked there after the financial crisis, helping draft the Volcker Rule, setting up the risk management structure to get information up to the Financial Stability Oversight Council, and building an agent-based models to help assess financial instabilities. I just went back to the Treasury for the first time since the start of the year to find that is has been gutted. This is not something that is on many people's minds, but it has implications that will be felt far beyond the time that a new administration comes on the scene that wants to return the department to a more normal state.

The reason, in a nutshell, is that what the Treasury does -- and what, for that matter the State Department, a department that is in even worse shape, does -- is not in any manuals. It is set on a foundation of what might be called oral tradition. People know how things work, how to get things done, and if the keepers of the oral tradition leave, it all has to start back up from scratch.

When a new administration comes in, it is the normal course of business for all the appointees to be replaced. Generally the new appointees come from outside government, and have not had previous experience in the Treasury. They rely on the staff, which mostly stays from one administration to the next. They know the process for getting things done, for developing and administering policy.

The Treasury is not a regulator per se, but it tends to be the center of communication -- and the referee when necessary -- for the agencies that do have regulatory authority: the SEC, FDIC, CFTC, etc. There is a process that has been honed over many administrations for doing this job, for acting as the central switchboard for dealing with financial issues. What happens when the switchboard operators walk out the door, and there is no operation manual to leave behind?


Thursday, October 26, 2017

On WealthTrack for the 30th Anniversary of the 1987 Crash

I was the guest for the PBS show WealthTrack for the 30th anniversary of the 1987 stock market crash.  Here is a link to it.


Thursday, October 19, 2017

The Crash of 1987 -- Happy 30th Anniversary

I was at the center of the October 19, 1987 stock market crash, when the U.S. equity market dropped 20% in a single day. The second chapter of my book, A Demon of Our Own Design recounts my experiences during the 1987 Crash, and provides an explanation of what went wrong.

The essence of the problem was a programmatic positive-feedback strategy, namely, the dynamic hedging program of portfolio insurance, coupled with the time disintermediation between the speed of the index futures market in Chicago and the more deliberate pace of those in the equity market in New York.

This is not so different structurally from what we have now with the time disintermediation between the ETFs and the underlying cash markets in the less liquid markets -- which is not observed when we have two-way flow -- coupled with various positive-feedback strategies such as volatility targeting and various flavors of what are essentially momentum strategies. Or other structural issues within the current financial system.

So, below is an edited version of Chapter 2 of A Demon of Our Own Design.

(If you have arrived here by going to my blog rather than to this post specifically, you need to click on the post to see the excerpt.)

Sunday, October 15, 2017

Can We have an ETF Meltdown?

What is the magic that allows us to have intraday liquidity through an ETF on a market that itself trades more or less by appointment?  Case in point: the high yield bond market.  Or emerging markets. Or just about any bond market short of sovereigns and maybe agencies.

Suppose there is a sudden rush for the exits in the high yield bond market. Those in the cash bonds know the drill. They will put in orders with the bank/dealer market makers. For a while those high yield bond trading desks will buy the bonds and hold them in inventory. But it won't take long for the trading desks to reach their capacity. After that point, they won't be buyers. They will act as agent -- also knows as riskless principal -- and look for someone on the other side of the trade. In the meantime the seller has to bide its time. The point is that on the cash bond side, it is not an intraday sort of a transaction. It can take days to find the other side for the trade. And anyone who is active in the high yield bond market knows that, so they structure their leverage and liquidity accordingly.

However, those in the ETFs by and large have no inkling that this is the way the market for high yield bonds works. As far as they can tell, the ETFs trade like an S&P 500 stock. You put in an order to sell, and you are done in minutes.

The reason there is typically high liquidity in the ETFs is that there is typically good two-way flow. And beyond the buyers and sellers are what are called authorized participants. The authorized participants keep the ETFs linked to the underlying cash bonds. They can create ETFs by buying up and bundling the underlying bonds, and they can take in the ETFs and unbundle them and sell the underlying bonds. In a functioning, two-way market, this all works the way arbitrage does for equities indexes. If the ETFs are at too high a price relative to the cash bonds, they grab the cash bonds to create and sell ETFs. If the ETFs are at too low a price relative to the cash bonds, they buy the ETFs and take the bonds to sell in the bank/dealer market.

It sounds simple, but it can't really be foolproof. You know there must be something that can go wrong when you have an instrument -- the high yield bond ETF -- that is as liquid as water even though the bonds it contains are almost the definition of an illiquid security. There is something akin to trying to cheat the law of conservation of momentum. And we all know that anytime something depends on some notion of arbitrage, things can go off the rails. I was in the middle of the portfolio insurance problems that led to the market crash in October, 1987. I knew all about option theory, but when the market was in free fall and the bid-offer spread for the S&P 500 futures was over a dollar, no one was in the mood to try to keep prices in line by doing delta hedging. Options traded in their own world. Implied volatilities were 80% and higher. The option market went into rotation -- trading one stock at a time throughout the day.

For the ETFs, things can go off the rails if the authorized participants can't do their job. If there is not a two-way market, and if the authorized participants' inventory is filled up with ETFs, and if they see that it will take days to get the bonds off of their hands, at the very time that prices are going crazy, they will be stepping away. At that point there is nothing tethering the ETFs to the cash market. The ETF market and the high yield bond market will each trade as their own thing, based on who needs to sell and who is there to buy. At that point it might as well be one market for Martian gravel and another for Enceladian ice cones.

Sure, that is taking it a little too far. There will be some real money investors who will finally step in and keep things from moving into a totally imaginary world. But for the time being the ETF market will, for all practical purposes, shut down. And, getting to the next chapter in this story, it is the "for all practical purposes" that matters.

A clear-thinking, experienced investor in, say, an ETF on an equity market index or gold or currency will not be bothered much by the failure of the high yield bond ETFs. They will get the point that the high yield ETF was creating a fiction of liquidity when there wasn't any, whereas in these equity and currency and commodity markets the underlying markets trade with pretty much the same liquidity as the ETF. But for many investors, all they will hear is that ETFs are in trouble. In the face of the major market dislocation in which the high yield bond problems are likely to be embroiled, people are already going to be in risk-off mode, and if they smell some sort of structural risk with these "newfangled ETFs" they will sell them, period. And there will be plenty of sources out there ready to spread the view that something is amiss.

And, getting to Soros's theory of reflexivity, the changing expectations that come from people in the market buying into this view means that those clear-thinking experienced investors will get out of these more liquid ETFs themselves. And if the authorized participants are still up for doing their job in those markets, that selling will feed back to drop the underlying markets in equities, currencies, and commodities.




Sunday, October 1, 2017

Out-there Scenarios I: ISIS is Funded by a Major Asset Management Firm

I break risk management into three levels, Versions 1.0, 2.0, and 3.0.

Risk Management 1.0 is the standard risk management of VaR and the like, where history is used as a guide, and thus where things work if the future is drawn from the same distribution as the past. Any approach that is looking at risks historically, whether using past prices or variance-covariance relationships or leverage numbers or credit ratings; whether using a normal distribution or a t distribution or a gamma distribution or a part of a distribution like semi-variance, is part of this.  If the future looks like the past in some specific ways, it works; if the futures deviates from the past it might not work.

Risk Management 2.0 is a reaction to the fact that the 1.0 methods failed during the 2008 crisis.  This failure is not surprising or unexpected by most of those working in risk management, because we understand the assumptions behind Version 1.0.  But sometimes this was not articulated well when the numbers were passed up the chain.  In any case, after 2008 risk management started to depend more visibly on stress testing. I say "more visibly" because anyone doing risk management over the past decades has done stress testing in one form or another. Certainly when there are non-linear risk-return tradeoffs, like with option exposures, it is a standard method.  But after 2008 it became de rigor in the analysis of bank risk, for example using CCAR.

And there is Risk Management 3.0, which I won't get into here.  It recognizes that a static stress will miss important dynamics that lead to feedback, contagion, and cascades.  And it is not something that can be readily addressed with the standard economics. You can check out my book, The End of Theory, or some of my papers while I was at the Office of Financial Research to get more on this.

Here I am focused on what we need to do before we can get to these dynamics: We need to know what is triggering a market dislocation. And we are particularly interested in triggers that are large in either magnitude or in the number of agents that are affected.  So even before worrying about the methods for dealing with crisis dynamics, the question to ask is: What can go wrong in a really big way.

I sometimes get at this by starting with something really extreme, and then dialing it back until it can be considered as a reasonable scenario. Reasonable does not mean it is likely to happen, but it also is not "what if an asteroid hits New York" either. Anyway, I want to run through some of the extreme scenarios that I have been thinking about. I'll put one out here and see if anyone responds, either with comments on it in particular, or with others that they are cooking up in a similar vein.

So, Out-there Scenario I: A large asset manager is rumored to be funding ISIS.

Suppose a rumor goes viral that a very large asset management firm is actually owned by, or at least is funding ISIS. This hits all the usual fake news outlets, and is then, of course, bounces into the real news if only as a "there is a rumor, unsubstantiated, making the rounds that...." The result will be large scale redemptions in that asset manager. This will start a downdraft in the markets. It will also lead to questions about other asset managers, and redemptions there as well. The resulting cascade could spread across the markets, erode confidence, and become a major market event.

Now, of course (at least I hope it is obvious) I am not saying specifically that this rumor is likely. But start with this and, as I suggested above, dial it down a bit. The point is, we can come up with scenarios where there can be massive redemptions in some particular major asset manager, and they can be exogenous to anything in the market, and on the face of it might be unreasonable.

One argument against this path to major redemptions hitting the market is that people can redeem by moving their holdings to another asset manager. If they do that there will be no actual selling of assets, and no market impact. This is the way investors will redeem if they continue to want to hold the assets and if they operate with professional aplomb. But the sort of people who would buy into a rumor like this are also likely to simply say, "give me my money", and then figure out what to do after that.

A little footnote: A few years ago the Office of Financial Research did a research study of the asset management community, with the key question being whether the largest asset should be SIFIs (systemically important financial institutions). The report was castigated, especially by the SEC, mostly, I think, because the SEC was honed for inter-agency rivalry. But in any case, no one threw the ISIS scenario into the report.