Is OCD obstructing long- term financial innovation ?

1. Is OCD obstructing long-term financial innovation? Dane RookSmith School of Enterprise & the Environment

2. Public Service Announcement Obsessive Capital Diversification (OCD) • Communicable • Early detection difficult • Potential lethality

3. OCD Diagnostics • Economic justification for diversification: Benefits > Costs • 3 (interlinked) budgets of asset owners Capital Governance Risk • Time • Expertise • Collective commitment AUM (£, $, …) “Error”

4. Interrogating Platitudes “Diversification isn’t a free lunch” • Not gratis • May be mal-nutritious • Can cause indigestion

5. Symptoms of OCD • Mistaking ends and means • Process, not state • Relative, not absolute • Moderator of expected returns, not generator • No better than best • No worse than worst • Dampens downside, does not eliminate • Conflation with hedging

6. Maximum Diversification: A Unicorn…? • Maximum Diversification • Own a share in everything of value,in proportion to its value • Single-factor exposure: systemic risk • Perpetual flux (non-stationarity) • Transaction and valuation cost impediments • Diversification spiral • Multi-factor exposure • Purposive or inadvertent selection/exclusion of specific risk factors (idiosyncratic exposures)

7. Maximum Diversification…or Dodo? • Tail events: extreme events, black swans, crashes, rare disasters, catastrophes… • Leptokurtic distributions (“fat tails”) • High impact, ‘low probability’ • Under many fat-tailed distributions optimality of diversification fails • Recognized since at least 1965 (E. Fama – Paretian forms) • Distributing eggs over many baskets presume independence of baskets • Selective exposure…factor-driven investment • Implicit or explicit

8. Governance Costs of OCD Time, Expertise, Collective Commitment “Resource limitations (time and expertise) remain at the centre of many of the fund governance problems that asset owners experience” • Monitoring, learning • Quickening pace • Widening universe • In-sourcing, out-sourcing • Compensation • Alignment/trust 78%

9. Collective Commitment in Governance

10. Convergence • Diversification spiral and portfolio overlap • Diminishing air-space leads invariably to crashes • (Not just true of aviation) • Quantification begets credibility, but if everyone happens to be reading the same treasure map, there is less pro rata • In portfolio management, doubloons = βs • βs typically historically-derived, ergo reverse-looking measurement of risk/opportunity • Not just popular in asset management, but also corporate finance applications • βs all about variances (of various stripes)

11. Variegated Variance • Variance matters because financial markets are stochastic, not deterministic • If they were deterministic, diversification would serve no purpose • Variance comes in two flavours: • Historical (ex post; realized moves) • Future (ex ante; plausible moves)

12. Errors and Counterfactuals Period 1 (historical) Period 2 (future) £121π=50% £110π=50% £110 £100 £88π=50% £80π=50% Russian nesting dolls of branchingWhat happened [is a subset of] what was considered [ is a subset of] what was possible

13. Variegated Errors • Flavours of error: • Aleatory: “casino-style” • Epistemic: structural misspecification • Outcomes? • Probabilities? Error rates……can have error rates… …can have error rates… …can have error rates… …can have error rates... £132π=? £121π=50% £110 £88π=50% £77π=?

14. Infinite Regress • Error ladders…at which rung do we leap off? • Alternatively, is it simply sufficient to admit that we “know that we might not know”, and would such a confession imply? • Pragmatic solution: tail-fattening

15. Mitigants • Self-criticality • Not being afraid to climb the error ladder • Aspiring to dig deeper into results, both when they work and when they don’t • Counterfactuals lend insight to possibilities • *GENUINE* innovation

16. Genuine Innovation • Emerging conventions are not durable innovation (in the global sense) • Illustration: credit derivatives • Control • Steering provisions • Comprehension (experience) • Don’t be wholly at someone else’s mercy and out of your depth… • Optionality

17. dane.rook@ouce.ox.ac.uk