Transcript www.efalken.com

Eric Falkenstein
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 In general, risk is not related to return
 At very low risk, there is a positive risk-return trade-off
effect
 At very high risk, there is a negative risk-return trade-
off
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 about Risk, Return, and Alpha
 I’m an economics PhD who has
worked as a quant, risk manager,
and portfolio manager
 www.defprob.com
 www.efalken.com
 falkenblog.blogspot.com
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 TA for Hyman Minsky in 1986
 Risk essence of interesting
economics, undefinable
 1994 dissertation documented
volatility and returns inversely
related
 Scope of evidence accumulating to a
critical point
 Present theory why risk not related
to return in general
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 After 45 years, there are no measure of risk that are
generally positively correlated with returns
Fama and French 1992
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Theory:
Longer hair people
are short
Omitted variable:
gender
Theory:
high beta firms
have high returns
Omitted variable:
size
 Fama-French rebrand ‘anomalies’ as ‘risk factors’
 No anomalies!
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 Oil prices
 Consumption growth
 Per-capita labor income
 Consumption/wealth ratio
 Statistical (latent) Factors
 Etc.
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 "Risk is not an add-on … it permeates the whole body
of thought.“
Robert C. Merton
“most returns and price variation come
from variation in risk premia”
John Campbell
FV
PV 
1 r  g
 g  PV
 g  PV
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Finance is “the only part of economics that works”
Andy Lo
Derivatives: risk neutral
expected value
Efficient Markets: hard to
make money
finance > economics > sociology
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‘it would be irresponsible to assume that [the
CAPM] is not true’
William Sharpe
‘theoretical tour de force’ though ‘empirically
vacuous’
Eugene Fama
‘stochastic discount factor(s) … so general, they
place almost no restrictions on financial data’
John Campbell
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75 % of finance professors would recommend using the
CAPM for capital budgeting,
10 % the Fama-French model,
Ivo
5 % some unspecified APT
Welch
Why use it?
1) CAPM ‘works’ if we ignore small firm effect
2) Everyone (ie, academic finance) does it
3) What else should we do?
4) Intuitive (it should work)
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 Risk aversion like aversion to smelliness
 Is mathematically consistent
 Given assumptions, asset pricing theory is correct
 CAPM special case of APT and SDF theory
 Like physics: mathematical beauty leads to truth
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 Leveraged Firms
 B vs. BBB rated Bonds
 Out-of-the-money options vs. at-the-money options
 S and C corps vs. equity indexes
 Highest volatility vs. modest vol stocks
 R rated movies vs. G rated movies
 Lotto vs. ‘quick pick’ lotteries
 50-1 horses vs. 3-1 horses
 Mutual funds, currencies, futures, countries, yield
curve
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Low vol
Low beta
Profitable
Unlevered
High vol
High beta
Unprofitable
levered
“Safe?”
“Risky?”
“Beautiful?”
 Nobody charges differently for capital within a bank
 Mortgages
 real estate
 credit cards
 Hedge fund: funding rates the same for
 distressed lending
 Convertible bonds
 pairs
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 Relative Utility  no general risk premium
 Instead of maximizing income, where each dollar is
worth less to us, we maximize our status.
 All risk like idiosyncratic risk, unnecessary so unpriced
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 “I want a product to be defined relative to a
benchmark”
Bill Sharpe
 ‘Risk, see Benchmarking’
Kenneth Fisher’s Only Three Questions that Count
 “small stocks were in a depression” in the 1980’s
Eugene Fama
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“I visualized my grief if the stock market went way up and
I wasn’t in it—or if it went way down and I was
completely in it. So I split my contributions fifty-fifty
between stocks and bond”
Harry Markowiz
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 People pay for hope  highly ‘risky’ assets generally
have lower returns
 Lottery returns
 high vol stocks
 Junk bonds
 Etc.
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 Optimal search theory
 Stopping problem
 Sample many times, choose best
 Find your competitive advantage implies some failure
 Fail 90% of the time
 Once you succeed and play again and again
 Education is about finding what you are good at,
getting better at it, doing it again and again
 Bad ‘rule’ for passive investing
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 People apply a risk premium when there is zero alpha
and they have to play  super low risk assets have low
returns (eg, cash)
AAA-BBB spread
3 month to 1 year in Treasury Bill maturity
Equity Risk Premium for efficient investors
No chance for alpha, because idiosyncratic volatility so low
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 Geometric vs. Arithmetic Averaging
 Survivorship Bias/Peso Problems
 Post WW2 Reduct. in Eq. Premium
 Taxes
 Adverse Market Timing
 Transaction Costs
 Sum
3.0%
3.0%
3.0%
2.0%
2.0%
2.0%
15.0%
 Most estimates around 3.5% for equity premium.
With these additions, the Marginal Investor clearly
could be seeing a 0% equity premium.
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 Invariably backward looking
 Strategies that have generated alpha
 Convertible bond arbitrage
 Pairs trading
 Convexity trade
 Not super mathematical, but very detailed
 Specific strategies with prospective alpha
 Index investing
 Beta arbitrage
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 Alpha is private information, valuable
 Force big ideas it down people’s throats
 Be sensitive about revealing small ideas
 Financial politics uses alpha as the key pretext
 Someone paid $500k, $5MM, $50MM because they
present alpha
 Politics are not inversely proportional to the stakes!
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 Take risks finding your comparative advantage
 Sample things, expect to pay to take such risks
 Don’t take risk investing in above average volatility
assets within any asset class, unless it’s a search for a
comparative advantage
 Don’t ‘risk adjust’ returns—Just like derivatives!
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