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Finding Alpha

Finding Alpha. Eric Falkenstein. Risk and Return. 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. Who am I and What This Is. about Risk, Return, and Alpha

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Finding Alpha

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  1. Finding Alpha Eric Falkenstein

  2. Risk and Return • 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

  3. Who am I and What This Is • 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

  4. Risk has been my Hobby Horse • 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

  5. The Problem • After 45 years, there are no measure of risk that are generally positively correlated with returns Fama and French 1992

  6. Theory: • Longer hair people are short • Omitted variable: gender • Theory: • high beta firms have high returns • Omitted variable: size

  7. Response to CAPM Failure • Fama-French rebrand ‘anomalies’ as ‘risk factors’ • No anomalies!

  8. Snipe hunt for factor that works • Oil prices • Consumption growth • Per-capita labor income • Consumption/wealth ratio • Statistical (latent) Factors • Etc.

  9. Praise for a Vacuous Theory • "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

  10. Still Considered The Gold Standard Finance is “the only part of economics that works” Andy Lo finance > economics > sociology Derivatives: risk neutral expected value Efficient Markets: hard to make money

  11. Praise for a Vacuous Theory ‘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

  12. Praise for a Vacuous Theory 75 % of finance professors would recommend using the CAPM for capital budgeting, 10 % the Fama-French model, 5 % some unspecified APT Why use it? • CAPM ‘works’ if we ignore small firm effect • Everyone (ie, academic finance) does it • What else should we do? • Intuitive (it should work) Ivo Welch

  13. Intuitive • 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

  14. …And Wrong • 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

  15. We can mathematize it: maximally attractive female waist-to-hip ratio around 0.7 physical beauty we can ‘see’

  16. If Risk is Priced, It's like Modern Art High vol High beta Unprofitable levered Low vol Low beta Profitable Unlevered “Safe?” “Risky?” “Beautiful?”

  17. Essential, Undefinable • 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

  18. My Theory • 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

  19. Everyone Benchmarks • “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

  20. Everyone Benchmarks “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

  21. My Theory • People pay for hope  highly ‘risky’ assets generally have lower returns • Lottery returns • high vol stocks • Junk bonds • Etc.

  22. Why pay for risk? • 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

  23. My Theory: Risk Premium Does Exist • 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

  24. Equity Premium • Geometric vs. Arithmetic Averaging 3.0% • Survivorship Bias/Peso Problems 3.0% • Post WW2 Reduct. in Eq. Premium 3.0% • Taxes 2.0% • Adverse Market Timing 2.0% • Transaction Costs 2.0% • Sum 15.0% • Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium.

  25. Alpha Examples • 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

  26. Effect of Miasma: Alpha Games • 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!

  27. Some Implications • 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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