Oh, the world. Go read Jeremy Grantham’s GMO quarterly letter; as always it’s pretty fun. Then go read this HSBC report that Paul Murphy wrote about on Alphaville. These are things you probably know already but are worth remembering. First, Grantham:
The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price. There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!
You probably knew that, though the numbers were new to me.* This though seemed like a useful breakdown:
Career and business risk is not at all evenly spread across all investment levels. Career risk is very modest, for example, when you are picking insurance stocks; it is therefore hard to lose your job. … Picking oil, say, versus insurance is much more visible and therefore more dangerous. Picking cash or “conservatism” against a roaring bull market probably lies beyond the pain threshold of any publicly traded enterprise. … Thus, because asset class selection packs a more deadly punch in the career and business risk game, the great investment opportunities are much more likely to be at the asset class level than at the stock or industry level. But even if you know this, dear professional reader, you will probably not be able to do too much about it if you value your job …
So basically: there are pennies to be picked up by fearless contrarians who pick the right insurance stocks, dimes to be picked up by contrarians picking the right equity sectors, and shiny gold dollars for those who know when to be in risk when others are in cash and vice versa.
The HSBC thing … won’t tell you how to do that. But it will tell you … how much of that you need to do, or something. It’s sort of neat; they smushed together thirty-four markets and deconstructed them with a principal component analysis, in which the returns are a linear combination of components and the first component is what explains the largest portion of the variance in asset returns. Call that component (they do) “risk on – risk off,” or RORO, which I suppose you have to pronounce as though you were Scooby Doo. If that factor is very high then you are swinging wildly between risk-on buying of developed market equities and risk-off buying of Treasuries or VIX or weirdly BAA corporate bonds; if that factor is very low then you are all “hmm I enjoy both wheat and gilts so why don’t I buy both?” or something like that. Anyway now it’s high so everything is a binary yay:
And then they give you some advice on how to trade that increasingly binary dynamic, which boils down to:
(1) embrace it (“trade the factor”) and just wake up each day deciding whether to be all in cash or all in levered S&P futures or whatever, about which they dryly note “the investor still needs to get the call right of course,” or
(2) fight it. Their advice on fighting it is, oh just go read it, there are ports and shopping malls, but they have some interesting things to say about dealing with RORO in pre-existing strategies. I liked one of them; if you’re interested, feel free to join me down below.**
So who will correlate the correlators? Or: what drove RORO up since 2007? HSBC has a bunch of answers and again you know them already: ETFs, globalization, and what they call “a new systemic risk factor” by which they mostly mean quantitative easing and other policy stuff. So, sure, though kind of boring.
Isn’t Grantham’s thing evocative? What if your model of what drives this RORO/correlation dynamic comes not from fundamentals or from regulator actions but from actions by career-minded investment managers? Pre-2007, career risk was mitigated by the fact that hey you could always get another job; blowing yourself up was just a rite of passage and there was always another bank. Since 2007, all the apocalyptic talk about the end of the financial world may make those with good gigs more reluctant to lose them – upping the value, to them if not to investors, of following the herd.
My Sister’s Pension Assets and Agency Problems (The Tension between Protecting Your Job or Your Clients’ Money) [GMO]
This correlated world [FTAV]
Risk On – Risk Off: Fixing a broken investment process [FTAV Long Room]
* I say unto you, idly, that in an economy with lots of debt, if GDP growth is sort of ROA and S&P growth is sort of ROE, shouldn’t the latter be more volatile than the former even absent investment-manager-careerism technicals? Exercise for the reader.
** I found this both likable and troubling:
Equity long/short strategies aim to trade the relative performance of equities at stock or sector level. The strategy might typically involve going long one sector and short another around some underlying benchmark portfolio, containing say the S&P 500. Low correlation to the underlying benchmark is an essential feature of the approach. Of course, in today’s world of high cross-asset correlations, equity market neutrality and RORO neutrality amount to the same thing.
[... but] active returns are now also RORO dominated, although for a different, more subtle reason. Equities have always been correlated with each other as they contain a common market component. Relative-value trades would see these market components generally offset to give market neutrality. The advent of RORO and higher equity correlations has dramatically changed this. Any failure to perfectly offset is now a problem as the common market components are, quite simply, bigger. When they don’t fully offset they leave a sizable market position left over, which dominates returns. These supposed “alpha” returns are thus correlated to the underlying equity market and behave like any other risky asset. They change leverage rather than provide alpha.
… [H]owever, there is hope. … Equity long/short strategies can be constructed in a more sophisticated way so as to make them market-neutral and hence RORO-neutral. This can be done using S&P futures or by more judicious basket construction. Fuller details of the problem and various solutions can be found in ‘Equity Insights: Alpha – not dead, just hiding’, 6 December 2011.
So I read the linked thing and gather that the basic point here is like “if you are long $500mm of Sector X and want to hedge by going short Sector Y, don’t just short $500mm notional of Sector Y; short [($500mm x Sector X beta) / (Sector Y beta)] worth of Sector Y so you’re flat beta rather than flat dollars.” Is that … I mean, is that news? Huh. We talked a little bit yesterday about smushing all your exposures into a ball and seeing where they poke up out of the ball and pushing them down where they poke up. Actually measuring your exposures seems like a key part of that. Notionals are at a first approximation a dumb way to measure exposures. Anyway. Thanks HSBC!
Also: if my earlier post was brought to you by Latin, this one is brought to you by Greeks. Look at them sometimes.