Tuesday, September 22, 2009

Asset Allocation

I appeared last Friday on a the PBS program WealthTrack, where the topic was asset allocation, in particular, as host Consuelo Mack put it, how to build an all weather portfolio. I was the skeptic of the group. I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather. Here is an encapsulation of my views from the program.

Asset allocation and risk appetite
One of the participants, asset allocation guru David Darst of Morgan Stanley, proposed various portfolios to protect against a 100-year flood, 30 to 70-year flood, a 25-year flood, etc. Those portfolios boiled down to putting less in risky assets and more in bonds; the more severe the flood you anticipate, the less risk you take. Of course, that will do the trick. If by asset allocation you mean determining where to set your risk tolerance dial, we’re all on board.

Asset allocation is like clapping with one hand
But the discussion of risk tolerance highlights that we can only go so far with asset allocation if we only look at assets. What matters is assets versus liabilities, because the liabilities determine our risk tolerance and, related to that, our demand for liquidity. It is impossible to formulate an ideal asset allocation strategy without knowing the liability stream those assets are intended to meet. There is no one-size-fits-all for asset allocation. This reminds me of an FAJ article I did back in the 1980s with pension actuary Jeremy Gold entitled “In Search of the Liability Asset”.

Diversification works well, except when it really matters
We all know the argument from Finance 101: If you hold 16 uncorrelated assets, your risk will drop by a factor of four. Well good luck with that.

During a crisis, when diversification really matters, correlations aren't near zero (as if they ever are). All that people care about is risk and liquidity. All assets that are highly risky drop, all assets that are less liquid drop. No one cares about the subtlety of earnings streams. It is like high energy physics. When the heat gets turned up high enough, matter is just matter, the distinctions between the elements is blurred away.


This is not to say that one should not try to diversify, but rather that one should not think diversification will work magic. It is a given that a portfolio should not be limited to U.S. Treasuries and S&P 500 stocks, because while it should not be oversold, diversification does have some benefit. And, on the other side, unless someone is still living in the 1970’s, it borders on the intellectually dishonest to trumpet a diversified portfolio by using the S&P 500 as the bogey. A college kid can construct a portfolio that will beat the S&P 500 on a risk-adjusted basis, because there are so many more markets available now. A better approach is to look at a given asset allocation versus its nearby well-diversified neighbors, and try to understand why one is better than the other.

Commodities do not form an asset class
This sounds heretical given what we have seen oil and gold do recently, but a lot of the reason that has happened is precisely because people are treating them as an asset class when they are not.


Commodities are not assets. They are factors of production. They do not generate returns, they have no claim on production. They have supply that flows out at a nearly fixed rate short term, and they comprise very small markets compared to the financial markets. If pension funds all decided to put two percent of their capital into commodities, two things would happen. First, that two percent would be a rounding error in their returns, no matter how commodities behaved. Second, they would swamp the supply of the commodities for economic purposes – i.e. for their true role as factors of production. I agree with Michael Masters’ view that oil prices were pushed up by this sort of financial activity. I might quibble with one chart or another, I might not couch it in the loaded terms of speculation.
But the subsequent behavior of the market demonstrated that he was right and Goldman and others who took the opposing view were wrong.

Inflation-Linked Bonds
Which brings me to inflation-linked bonds. At the close of the program we all were asked for one investment recommendation. In one form or another we all focused on the same one: inflation-linked bonds. But I would not carve them out as a distinct asset class any more than I would commodities -- though unlike commodities, at least I think they are an asset. They are one of many assets that load on the inflation factor. If you have a long-term view, equities are also decent inflation hedge. After all, over time prices adjust, and so do earnings. And, as with commodities, the supply of inflation-linked bonds is low; there is a liquidity premium to pay.

I think what has elevated inflation-linked bonds from the category of “asset” to that of “asset class” is memories of the 1970s, a heyday for inflation-linked bonds. If you could have held them during the stagflation period, you would have looked golden; they would have given you a Sharpe Ratio of over 1.0 while many other assets was flat-lining. If I were building a simulation to beat the market on an historical basis, I would add in inflation linked bonds just for the pop they would give in that decade.

Wednesday, September 16, 2009

Regulation in Defense of Capitalism

Will regulation hobble capitalism? I think the opposite is true. Properly done, government regulation of the financial industry will move the industry closer to the capitalist ideal. By capitalism, I mean where those who take the risks and put up the money get the fruits of their labor. And, importantly, where those who take the risks and put up the money actually do take the risks, bearing the full costs of failure as well as success. As things stand now, we have a finance industry that is capitalist when things are going well and socialist when things are going poorly -- right-tail capitalist/left-tail socialist.

Capitalism means bearing the costs
I sometimes miss the rugged beauty of Utah, where I spent some of my pre-Wall Street years. From my house on the foothills of the Wasatch mountains, I could see the cliffs of Mount Nebo to the south, nearly fifty miles away. Ten miles north, the western face of Mt. Timpanogas, capped with snow into early summer. To the west, the sun reflecting on Utah Lake. Oh, and on the eastern shore of the lake, the black smoke billowing out the stacks of Geneva Steel.

Geneva Steel was built to produce steel during the war effort, and kept in operation until seven years ago. It teetered at the edge – and at least two times over the edge – of bankruptcy, closing for good in 2002. Left behind were assorted furnaces, presses and scrap metal sold to a Chinese steel producer, and a giant pond of toxic sludge.

Fortunately, we’ve learned a thing or two about toxic sludge in steel production. The steel producer, in this case the original parent of the Geneva plant, U.S. Steel, has to set aside a fund to pay for the clean-up. The sludge is part of the production process, and the clean-up is a cost of production, even though it is a cost that is not realized until many years down the road. As a result, steel costs are a little higher and the shareholders fare a little worse than if this longer-term expense were not forced onto the producers. The regulation that requires setting aside funds for the clean-up might be considered intrusive to the core values of capitalism. But it is the contrary. It is forcing the steel mills to recognize all of their costs rather than leave society to foot part of their bill.

Wall Street’s toxic sludge
Wall Street has its own forms of toxic sludge, longer-term costs and negative externalities from products and strategies: The increase in the risk of crisis that comes from the opacity of complex derivatives; the fat tail risk of positions that are short credit or liquidity; negative gamma trading strategies, strategies that in various guises are like naked call writing, making money most of the time, but on occasion failing spectacularly; the forced deleveraging and liquidity crises that come from high leverage.

These costs are easy for the Wall Street capitalist to ignore, because unlike the sludge pond behind the steel mill, they are not visible until they finally hit. Indeed, they are not even deterministic. They might hit or they might not – so what we have in financial markets is invisible and probabilistic toxic sludge. Which makes sludge-producing strategies all the more popular with banks and traders, because if you can do things where you don’t have to bear some of the costs, the odds are better you will turn an apparent profit.

The limited liability assault on capitalism
The banks and trading firms don’t have to bear these costs because of the widespread use of limited liability. Limited liability creates a ‘heads I win tails you lose’ relationship. The template for limited liability is the corporation, a template that has been copied to create the trader’s option and short-term compensation, paid out before the full costs of a product or strategy are manifest.

If I want to get the most value out of limited liability, I will gravitate toward fat tailed and complex businesses, where most of the time I pump money out with regularity, but face some prospect of a catastrophic loss. How catastrophic? The bigger, the better. It doesn’t matter to me how bad things get once they have passed my liability limit. And the larger that catastrophic case, the more costs I am passing on, and thus if a general risk-return relationship holds, the more return I will get as long as the catastrophe is kept at bay.

Put in other terms, I will look for businesses and strategies that produce the highest level of costs that I can slough off, that will be unrecognized by others. Is this the direction Wall Street has gravitated? Are the exposures of traders and banks biased toward taking credit risk, being short liquidity risk, and short gamma? Do they prefer the complex to the simple? Do they push leverage as far as regulation allows?
Regulation and capitalism
Regulation that exposes this and forces the trader or bank to absorb these costs makes the markets more true to capitalist ideals. Capitalist regulation forces the producers to recognize all of their costs. It undoes the harm to capitalism that comes from limited liability and its kissing cousins, the trader’s option and short term compensation deals. The flip side is that with capitalist regulation, no one can take on more risk than they are capable of absorbing. Which means requiring higher levels of capital on the one hand, restricting leverage on the other, which in turn means reduced capacity to generate high returns.

The aspiring capitalists among us will decry such regulation because it invariably makes our lives harder; we can’t make as much money. But if the reason is that the regulation is now forcing us to bear all of the costs of our enterprise, then we are feeling the pain of having the socialist trappings removed, and entering into a more robust capitalist regime.

Friday, September 11, 2009

The Risks of Financial Modeling: VaR and the Economic Meltdown -- Testimony to the House

I testified before the House for the hearing, "The Risks of Financial Modeling: VaR and the Economic Meltdown". This is my written testimony. This is the video of the hearing.

I testified in the Subcommittee on Investigations and Oversight. This subcommittee includes a number of members -- including the Chairman -- who also are on the Financial Services Committee, and so the hearing in this venue will find its way back there.

I shared the panel with Nassim Taleb. While we naturally had disagreements in some areas, I think by and large we presented the message. (For example, see this FT post). I enjoyed meeting him in person for the first time.

Friday, September 4, 2009

HALT: Imposing Limits on High Frequency Trading

In my first post on high frequency trading, I ended with a somewhat tongue-in-cheek proposal for a High-Frequency Arms Limitation Treaty, or HALT. The more I observe of the concern for this strategy, the more pervasive it becomes, and the more apparent abuses that come to the fore, the more this proposal moves from the realm of satire to the real.
As I mentioned in that post, I do not think the market benefits from moving trading speeds faster and faster in the millisecond range. But what the need for speed does do is burn through untold hundreds of millions of dollars for all the competitors to keep up with one another. And just as the complexity of derivatives can lead to the obfuscation of non-economic or manipulative operations, so can operations that blur past the screen before anyone can observe what is happening.

Here are some questions regulators should ask -- maybe they already are asking them -- to see if HALT makes sense:

What is the economic benefit of trading with twenty millisecond latency versus thirty millisecond latency?

What is the economic cost and what are the barriers to entry erected by pushing the latency envelope?

What speed of trading leads the marginal costs of obfuscation to dominate the marginal benefit for the end investor? By obfuscation, I mean the creation of a cloud around the trading activity that prevents the regulators from being able to assure the investors are being protected and the market is operating transparently and fairly.
What level of trades per second becomes problematic in terms of obfuscation versus practical and economic value? The focus with high frequency trading is the latency, but focus also should be given to the number of trades done per second. It is not just a matter of speed of trading, it is the cloud of noise that comes from what can be hundreds of different trades on one security all flowing from one trading firm into the market in a very short time period.
The answer to these question might be limits on the latency of trades and the number of trades per second allowed in any one security by private and proprietary trading firms.