I will scream if I see again the comment that Japanese deflation tends to make consumers defer purchases. This is ridiculous. If an economy has 2% deflation a year then a good that costs 100 will cost 98 after a year. Who'd defer the purchase for this saving? The convenience of the good is surely worth at least this much! And how many people put off buying computers because they'd be at least 20% more cost-effective if they waited a year? After an initial lag the steady state emerges.
People who make this statement on deferring consumption have mislearned the lesson from bouts of 10%-20% deflation. When deflation is at these levels then people may defer purchases, but on the other hand the deflation is most probably caused by people deferring purchases.
Tuesday, December 15, 2009
Thursday, November 12, 2009
The danger of indexes
http://online.wsj.com/article/SB10001424052748704576204574529722299099570.html#articleTabs%3Dcomments
HEARD ON THE STREET
NOVEMBER 11, 2009, 1:30 P.M. ET
Contingent Capital's Tricky Path
By RICHARD BARLEY
Contingent convertibles may become a key part of the future bank-capital landscape, but their path to widespread acceptance is unlikely to be smooth. The nascent instruments this week suffered a setback in an arcane yet critical row over their inclusion in bond indexes used by investors around the globe. The outcome could be reduced investor appetite for the bonds.
Lloyds Banking Group is currently offering to exchange as much as £7 billion ($12 billion) of contingent convertibles for existing subordinated debt as part of a bigger £21 billion capital raising to free itself from the U.K. government's toxic-asset insurance plan. The notes have a fixed maturity but will convert into equity if Lloyds's core Tier 1 capital ratio falls to less than 5%.
Many bond investors, the traditional buyers of bank hybrid capital, don't want these bonds included in bond indexes because they are prohibited from owning equity. Bank of America Merrill Lynch, which compiles some of the most widely watched bond indexes, initially agreed, then changed its mind only to change it back again after the Association of British Insurers complained that investors might be forced to buy the notes because of their inclusion, but then be forced to sell upon conversion at a time of market stress. That is a brave but welcome decision. Barclays Capital also isn't including the notes in its corporate-bond indexes; iBoxx is making its mind up about them.
Lloyds's deal may work, as it is making investors an offer that is difficult to refuse--unexchanged bonds are set to have payments blocked by the European Commission as a condition of state aid. But the bond debate is a blow for any hope that contingent convertibles are the solution to banks' capital woes. It also underlines the limitations of the structure: While undoubtedly an improvement on traditional hybrid bonds, their success depends on a similar ambiguity over where they sit in the capital structure between debt and equity. That makes them an unlikely silver bullet.
Write to Richard Barley at richard.barley@dowjones.com
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
My Comment
What a sad commentary this is on the investment management industry, and a classic example of the tail wagging the dog. In deciding whether something is a good investment for the medium to long-term, there should be no consideration of whether it is in an index or not. That index inclusion is a major stumbling block shows how many of the fund managers, despite their high fees, have abrogated the most basic role of an investment manager.
HEARD ON THE STREET
NOVEMBER 11, 2009, 1:30 P.M. ET
Contingent Capital's Tricky Path
By RICHARD BARLEY
Contingent convertibles may become a key part of the future bank-capital landscape, but their path to widespread acceptance is unlikely to be smooth. The nascent instruments this week suffered a setback in an arcane yet critical row over their inclusion in bond indexes used by investors around the globe. The outcome could be reduced investor appetite for the bonds.
Lloyds Banking Group is currently offering to exchange as much as £7 billion ($12 billion) of contingent convertibles for existing subordinated debt as part of a bigger £21 billion capital raising to free itself from the U.K. government's toxic-asset insurance plan. The notes have a fixed maturity but will convert into equity if Lloyds's core Tier 1 capital ratio falls to less than 5%.
Many bond investors, the traditional buyers of bank hybrid capital, don't want these bonds included in bond indexes because they are prohibited from owning equity. Bank of America Merrill Lynch, which compiles some of the most widely watched bond indexes, initially agreed, then changed its mind only to change it back again after the Association of British Insurers complained that investors might be forced to buy the notes because of their inclusion, but then be forced to sell upon conversion at a time of market stress. That is a brave but welcome decision. Barclays Capital also isn't including the notes in its corporate-bond indexes; iBoxx is making its mind up about them.
Lloyds's deal may work, as it is making investors an offer that is difficult to refuse--unexchanged bonds are set to have payments blocked by the European Commission as a condition of state aid. But the bond debate is a blow for any hope that contingent convertibles are the solution to banks' capital woes. It also underlines the limitations of the structure: While undoubtedly an improvement on traditional hybrid bonds, their success depends on a similar ambiguity over where they sit in the capital structure between debt and equity. That makes them an unlikely silver bullet.
Write to Richard Barley at richard.barley@dowjones.com
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved
My Comment
What a sad commentary this is on the investment management industry, and a classic example of the tail wagging the dog. In deciding whether something is a good investment for the medium to long-term, there should be no consideration of whether it is in an index or not. That index inclusion is a major stumbling block shows how many of the fund managers, despite their high fees, have abrogated the most basic role of an investment manager.
Monday, October 26, 2009
Mentioned in the right circles
I'm not sure whether the bloke in the cartoon is meant to be me - us blokes with beards look all alike.
http://www.chinadaily.com.cn/cndy/2009-10/20/content_8817570.htm
http://www.chinadaily.com.cn/cndy/2009-10/20/content_8817570.htm
Thursday, October 15, 2009
Feeling good
I suppose I should feel good that the other side of the court case for which i'm an expert witness has asked the judge to rule most of my evidence inadmissable. That means they're scared, right?
Monday, October 12, 2009
Capital buffers for market risk
The approach to estimating capital and the market risk of portfolios is a bit confused at the moment. If we think of capital as the buffer that we need to hold against some surprisingly bad event, then it makes no sense to estimate it by looking at current and past portfolios. The Board needs to tell the traders how much money it wants to put at risk from a trading portfolio. Then the risk model can assess the probability of this occurring given the current portfolio and current market conditions to ensure that the VaR limit is within the Board approved limits.
How does the Board come to its decision? Gut feel can be one way. Another would be to look at the historical risk positions that have been taken. Both approaches need to be reconciled.
How does the Board come to its decision? Gut feel can be one way. Another would be to look at the historical risk positions that have been taken. Both approaches need to be reconciled.
Wednesday, July 1, 2009
Risk management and the Foundation Trilogy
In the INARM actuarial blog, Dave Ingram made the following comment:
I had an interesting discussion over the weekend with someone about the original Foundation Trilogy.
It seems that those books provide a very good paradigm for risk management.
1. As mentioned by Steve, the "psychohistory" which I always envisioned as a massive computer model that looked into the future and made probabilistic predictions of likehood of possible courses of events. From this work a plan was developed.
2. A "Black Swan" event that was not anticipated by the models in book two - "The Mule" . This Black Swan event invalidates the original models.
3. A group of people, "the second foundation", who were charged with updating the model for actual events as they deviated from the original projection. As well as implementing corrective actions to bend events back towards achievement of the original goals.
Asimov anticipated an extremely important aspect of this prediction business. The working of the original plan and the adjustments of the second foundation were kept secret from the world at large. Asimov understood the impact of knowledge of the plan on the actions of the people.
These books were written in the early 1950's and there are several fundamental ideas that we have not yet fully understood or mastered in risk management.
This prompted my reply:
Very good points! Now for a short riff on this theme with insights into modern risk management practice.
Unfortunately "Second Foundation" wouldn't work as Asimov assumed for his fictional work. The problem is how can we maintain a proper risk management culture? Culture evolves much more quickly than physical characteristics because its transmission mechanisms - memes - have a much greater mutation rate than the genes, and the environment in which the memes multiply is much more chaotic than the physical world (except when meteorites hit). Hence the memetic repair mechanisms needed to keep the culture semi-stable (analogous to the genetic repair mechanisms to cull out egregious mutations) need to have attention paid to them. Three important repair mechanisms for risk management culture are regulation, shareholder influence on Boards, and separation of duties. None of these are included in the "Second Foundation", hence the starting point of my riff.
The information now coming out on Countrywide shows the importance of all these mechanisms for the maintenance of corporate culture.
Another point Dave. Random statements - like mentioning the Foundation Trilogy - are an extremely effective way of getting thought patterns into new pathways - an essential thing for a risk manager (as distinct from a compliance manager).
I had an interesting discussion over the weekend with someone about the original Foundation Trilogy.
It seems that those books provide a very good paradigm for risk management.
1. As mentioned by Steve, the "psychohistory" which I always envisioned as a massive computer model that looked into the future and made probabilistic predictions of likehood of possible courses of events. From this work a plan was developed.
2. A "Black Swan" event that was not anticipated by the models in book two - "The Mule" . This Black Swan event invalidates the original models.
3. A group of people, "the second foundation", who were charged with updating the model for actual events as they deviated from the original projection. As well as implementing corrective actions to bend events back towards achievement of the original goals.
Asimov anticipated an extremely important aspect of this prediction business. The working of the original plan and the adjustments of the second foundation were kept secret from the world at large. Asimov understood the impact of knowledge of the plan on the actions of the people.
These books were written in the early 1950's and there are several fundamental ideas that we have not yet fully understood or mastered in risk management.
This prompted my reply:
Very good points! Now for a short riff on this theme with insights into modern risk management practice.
Unfortunately "Second Foundation" wouldn't work as Asimov assumed for his fictional work. The problem is how can we maintain a proper risk management culture? Culture evolves much more quickly than physical characteristics because its transmission mechanisms - memes - have a much greater mutation rate than the genes, and the environment in which the memes multiply is much more chaotic than the physical world (except when meteorites hit). Hence the memetic repair mechanisms needed to keep the culture semi-stable (analogous to the genetic repair mechanisms to cull out egregious mutations) need to have attention paid to them. Three important repair mechanisms for risk management culture are regulation, shareholder influence on Boards, and separation of duties. None of these are included in the "Second Foundation", hence the starting point of my riff.
The information now coming out on Countrywide shows the importance of all these mechanisms for the maintenance of corporate culture.
Another point Dave. Random statements - like mentioning the Foundation Trilogy - are an extremely effective way of getting thought patterns into new pathways - an essential thing for a risk manager (as distinct from a compliance manager).
Tuesday, June 9, 2009
Credit Default Swap auctions
Here's a summary of CDS auctions I've incorporated into my yet-(never?)to-be-released book on Financial Risk Management. Nice to know how they work.
CDS Auctions[1]
A method for gauging an official price at which to settle CDS contracts is not the only rationale for an auction. There are a number of credit market indexes that are used as the basis for various derivative contracts. An auction gives a reference price that can be included in all indexes and so reduces basis risk for people who have matched physical and derivative positions via a number of different indexes.
The auction proceeds in two rounds and all prices are based on a par value of 100.
In the first round brokers submit a bid and offer on their own behalf and that of their clients The bid-offer spread may not differ by more than 2. If desired, a request can be made to buy or sell a physical amount of bonds – this amount may not be in excess of the party’s market position. If the highest bid is higher than the lowest offer then both quotes are removed from the pool; this step is the repeated. When all bids are below all offers the unweighted average of the highest 50% of bids and lowest 50% of offers is calculated. This is the inside market midpoint. The net sum of the requests to buy and sell physical instruments is called the open interest. If the open interest is zero then the inside market midpoint is the final auction settlement price for physical and derivative contracts. Otherwise round 2 starts, which clears the open interest.
Dealers can then submit any number of limit orders (size and price) for physical instruments, with a limit of ±1 of the inside market midpoint. If the open interest is to sell bonds then the limit on the buy orders is a dollar above midpoint, if the open interest is to buy then the limit on sell orders is one dollar below the midpoint. The open interest is then matched against the limit orders and the clearing price is the final auction settlement price for all physical and derivative instruments.
[1] This information is summarised from Helwege et al http://ssrn.com/paper=1407272
CDS Auctions[1]
A method for gauging an official price at which to settle CDS contracts is not the only rationale for an auction. There are a number of credit market indexes that are used as the basis for various derivative contracts. An auction gives a reference price that can be included in all indexes and so reduces basis risk for people who have matched physical and derivative positions via a number of different indexes.
The auction proceeds in two rounds and all prices are based on a par value of 100.
In the first round brokers submit a bid and offer on their own behalf and that of their clients The bid-offer spread may not differ by more than 2. If desired, a request can be made to buy or sell a physical amount of bonds – this amount may not be in excess of the party’s market position. If the highest bid is higher than the lowest offer then both quotes are removed from the pool; this step is the repeated. When all bids are below all offers the unweighted average of the highest 50% of bids and lowest 50% of offers is calculated. This is the inside market midpoint. The net sum of the requests to buy and sell physical instruments is called the open interest. If the open interest is zero then the inside market midpoint is the final auction settlement price for physical and derivative contracts. Otherwise round 2 starts, which clears the open interest.
Dealers can then submit any number of limit orders (size and price) for physical instruments, with a limit of ±1 of the inside market midpoint. If the open interest is to sell bonds then the limit on the buy orders is a dollar above midpoint, if the open interest is to buy then the limit on sell orders is one dollar below the midpoint. The open interest is then matched against the limit orders and the clearing price is the final auction settlement price for all physical and derivative instruments.
[1] This information is summarised from Helwege et al http://ssrn.com/paper=1407272
Vale Peter Bernstein
Bernstein's Against the Gods is a must read for anybody interested in the study of risk. And that means everybody - it is a very easy read.
Thursday, May 21, 2009
UBS and statistics
Last night I read the risk management section of UBS's 2008 annual report. What is it about some risk officers that makes them have a blind spot concerning basic statistical principles?
Take a look at this quote from p130 As UBS's VaR model uses a look-back period of five years it does not respond quickly to periods of heightened volatility as experienced in 2008. ... UBS experienced 50 backtesting exceptions in 2008 compared with 29 backtesting exceptions in 2007. Here backtesting is concerned whether a 99% 1-day VaR is exceeded. No backtesting failures had been seen from 1998 to 2006. So, in a period of about 9*250 = 2250 days, where UBS should have seen about 22 exceptions, it saw none, and in a period where it should have seen 2 or 3 exceptions it saw 50 ! What do they say about this? These results highlight the limitations of VaR ... Now come on guys! Why don't you admit that your VaR model is rubbish. You had 9 years of experience showing you the model didn't work and still you kept at it. Now it's failed the other way, and you still keep the model in your armoury?
How do UBS describe VaR? VaR is a statistically based estimate of the potential loss on the current portfolio from adverse movements ... VaR is derived from a distribution of potential losses.
The comment that VaR is statistical is a common theme in UBS's discussion. OK, I'll admit it's statistical, but UBS's use of it is lousy statistics. The way UBS describe this makes it sound like it's a reasonably OK statistical tool, but with some limitations, which they describe. This is bordering on the completely misleading, and here's why.
Using a simple 5 year historical simulation to calculate VaR means you are calculating an unconditional VaR i.e. you are not conditioning your estimate of VaR on the current market conditions. VaR is supposed to be an estimate of what you could lose tomorrow with some probability. It makes no sense to calculate the distribution of possible losses tomorrow without taking into account that we may be in a period of high market volatility. Basel II capital requirements are that we need to hold capital that is suitable for the current conditions. If we have high volatility then we need to increase our VaR immediately, not wait a few months until it starts to be a significant part of our 5 year data set.
The continued production by UBS risk management group of this VaR statistic shows that they do not understand some basic ideas of risk measurement. It is a number that has almost no useful interpretation for day-to-day risk management or for capital management. That the Swiss regulator allows this measure to be featured so prominantly in the annual report shows that they have not adopted a sufficiently rigorous supervisory role over their banking system. That similar measures are used in other banks worldwide show that there is still something seriously wrong in banking risk management.
Take a look at this quote from p130 As UBS's VaR model uses a look-back period of five years it does not respond quickly to periods of heightened volatility as experienced in 2008. ... UBS experienced 50 backtesting exceptions in 2008 compared with 29 backtesting exceptions in 2007. Here backtesting is concerned whether a 99% 1-day VaR is exceeded. No backtesting failures had been seen from 1998 to 2006. So, in a period of about 9*250 = 2250 days, where UBS should have seen about 22 exceptions, it saw none, and in a period where it should have seen 2 or 3 exceptions it saw 50 ! What do they say about this? These results highlight the limitations of VaR ... Now come on guys! Why don't you admit that your VaR model is rubbish. You had 9 years of experience showing you the model didn't work and still you kept at it. Now it's failed the other way, and you still keep the model in your armoury?
How do UBS describe VaR? VaR is a statistically based estimate of the potential loss on the current portfolio from adverse movements ... VaR is derived from a distribution of potential losses.
The comment that VaR is statistical is a common theme in UBS's discussion. OK, I'll admit it's statistical, but UBS's use of it is lousy statistics. The way UBS describe this makes it sound like it's a reasonably OK statistical tool, but with some limitations, which they describe. This is bordering on the completely misleading, and here's why.
Using a simple 5 year historical simulation to calculate VaR means you are calculating an unconditional VaR i.e. you are not conditioning your estimate of VaR on the current market conditions. VaR is supposed to be an estimate of what you could lose tomorrow with some probability. It makes no sense to calculate the distribution of possible losses tomorrow without taking into account that we may be in a period of high market volatility. Basel II capital requirements are that we need to hold capital that is suitable for the current conditions. If we have high volatility then we need to increase our VaR immediately, not wait a few months until it starts to be a significant part of our 5 year data set.
The continued production by UBS risk management group of this VaR statistic shows that they do not understand some basic ideas of risk measurement. It is a number that has almost no useful interpretation for day-to-day risk management or for capital management. That the Swiss regulator allows this measure to be featured so prominantly in the annual report shows that they have not adopted a sufficiently rigorous supervisory role over their banking system. That similar measures are used in other banks worldwide show that there is still something seriously wrong in banking risk management.
Thursday, May 14, 2009
Normal distributions
Let's get this straight! If X is Normal and Y is Normal then X+Y is Normal only if X and Y come from a bivariate Normal distribution.
Simple counterexample - X and Y are both standard Normal; X=-Y if abs(X)<1; X=Y otherwise.
Simple counterexample - X and Y are both standard Normal; X=-Y if abs(X)<1; X=Y otherwise.
Sunday, April 19, 2009
One area in which I'd like to give further thought is looking at the formal (logical) language in which we can discuss risk. First order predicate calculus seems too powerful. My gut feel is that first order multiplicative intuitionistic linear logic would be suitable. In this logic, when you have riskA and riskB, then there are things that can happen that are not just the standard interactions of riskA and riskB. For a physical analogy, consider entangled photons, which can arise when we physically have a state of two photons, but there is no way in classical physics that we can model what entangled photons do. In fact, in classical physics they can't exist. Quantum physics has a similar structure to intuitionistic linear logic. The possible states with two photons "photonA and photonB" are more than you can get by just looking at the individual states of photonA and photon B - "riskA and riskB" is different from "riskA and riskB" (See the difference in the logical operator? The "and" is not the same.)
Lots more thinking to do.
Lots more thinking to do.
Tuesday, April 7, 2009
What is risk?
For some reason I've been involved in discussions, over the last couple of days, as to what risk is. Some say its an event, some describe it as an emergent process from a complex organisation (Milliman), ISO31000:2009 say it's the effect of uncertainty on objectives. I think we need to make sure that we don't have a category error creeping into our thinking. A suitably generic notion of risk is that it's exposure to something that may be disadvantageous in some way. We can then start from here.
Tuesday, March 31, 2009
Just-in-time and manufacturing declines
What happens if lots of companies have tightened up their supply chains to cut down on inventory costs, and the economy goes into a severe recession? The shock of lower sales should be transmitted through the supply chain much more quickly than it has been in earlier bad recessions. Maybe the big, sudden drop in manufacturing output is partly driven by this factor. In which case, what we're doing is getting to the bottom of the cycle much quicker than before.
With any luck, the bounce out will be equally quick. I'm not holding my breath.
With any luck, the bounce out will be equally quick. I'm not holding my breath.
Friday, March 6, 2009
Some Boards are getting up my nose!
It is very difficult for the general body of shareholders to affect the Board in any meaningful way. While nominally being elected by the shareholders, a Board is self-propagating unless something seriously bad happens.
Despite all the best will in the world, such an environment is dynamically unstable. A good Board would ensure it has regular external and independent reviews of its structure, capabilities, and mechanisms. It would embrace robust discussions at AGMs and would welcome feedback from shareholders and a constructive dialogue (with the shareholders' mostly determining what is constructive). Because of the dangers of ossification, there would be a regular turnover of Board membership.
This process is unstable because in the absence of shareholders being able to affect the Board, any sufficiently large departure of the Board from its exacting standards causes its self-correction mechanisms to fail. Self-serving rationalisations can be made for why the independent Board review got it wrong, or the Board reviewer may not be changed regularly enough and so loses their external and independent nature (no matter how good you are, a close working relationship over a number of years destroys the independence - we have tons of psychological evidence for this in general, and I can't see why Board reviewing (and company auditing for that matter) would be any different). A small departure from good behaviour allows slightly larger departures, and so on in ever widening spiral of departure from best practice. And all the time the Board is arguing it's doing a good job, and steadily entrenching themselves - for the good of the company! And they believe it.
OK, so how to fix it. We know how - a mechanism whereby the beneficiaries of the company (the owners) can exercise control over the executive function, which is essentially by electing the Board. While I object to some of the activities of proxy advisors, they are doing a good job by getting more coordinated action by the end shareholders.
Despite all the best will in the world, such an environment is dynamically unstable. A good Board would ensure it has regular external and independent reviews of its structure, capabilities, and mechanisms. It would embrace robust discussions at AGMs and would welcome feedback from shareholders and a constructive dialogue (with the shareholders' mostly determining what is constructive). Because of the dangers of ossification, there would be a regular turnover of Board membership.
This process is unstable because in the absence of shareholders being able to affect the Board, any sufficiently large departure of the Board from its exacting standards causes its self-correction mechanisms to fail. Self-serving rationalisations can be made for why the independent Board review got it wrong, or the Board reviewer may not be changed regularly enough and so loses their external and independent nature (no matter how good you are, a close working relationship over a number of years destroys the independence - we have tons of psychological evidence for this in general, and I can't see why Board reviewing (and company auditing for that matter) would be any different). A small departure from good behaviour allows slightly larger departures, and so on in ever widening spiral of departure from best practice. And all the time the Board is arguing it's doing a good job, and steadily entrenching themselves - for the good of the company! And they believe it.
OK, so how to fix it. We know how - a mechanism whereby the beneficiaries of the company (the owners) can exercise control over the executive function, which is essentially by electing the Board. While I object to some of the activities of proxy advisors, they are doing a good job by getting more coordinated action by the end shareholders.
Thursday, March 5, 2009
A nice piece from the FT on the level of losses from the "AAA" rated tranches of the sub-prime linked CDOs. There is still going to be a lot more losses to be revealed presumably.
http://www.ft.com/cms/s/0/2970532c-0421-11de-845b-000077b07658.html
http://www.ft.com/cms/s/0/2970532c-0421-11de-845b-000077b07658.html
Thursday, February 26, 2009
Case-Shiller index
The Case-Shiller index for house prices shows a marked difference between the 10 cities with the highest returns between 2002 and 2005, and the 10 cities with the lowest returns over that period. (Index values as released at 24 Feb 09)
It's obvious that in the "non-boom" cities the price declines have been much more muted than in the boom cities. What is worrying is that the recession has now hit the prices of cities that didn't boom. Declines in these prices is now as fast as for the boom cities.
But the behaviour of the non-boom cities was also more muted back in the early 1990s. We definitely have a heterogenous group of cities.
Copies of spreadsheet available for those interested.
Saturday, February 14, 2009
Keynes and the Great Depression
With all the mention of JM Keynes and his analysis of the 1930s Depression, it's interesting to note that his father was on a Royal Commission analysing the 1890s economic depression.
Friday, February 13, 2009
Qualitative and quantitative information
Another question from LinkedIn - Performance & Risk Analysis group
How do you integrate qualitative and quantitative information in a systematic way?
In mathematics, there exists the Bayesian approach. Related to that, we know the Black/Litterman approach. In medicine and other disciplines, there are "evidence-based" approaches - what is your take on enhancing quantitative with qualitative information in a structured manner?
First, there is no way we can know what is the optimum portfolio. Estimation error means we have a distribution of portfolios that could be optimal.
Secondly: We can use resampling or bootstrapping to give us an idea of this distribution.
Thirdly: Choose a portfolio in this cloud of possible optimums that is line with your qualitative information. By the very nature of qualitative information, this has to be subjective.
Fourthly: Be prepared to have to defend this approach from people who think that it lacks rigour. When I've seen the arguments of such people I find that what is lacking is a rigourous knowledge of the statistical underpinnings of portfolio arithmetic.
How do you integrate qualitative and quantitative information in a systematic way?
In mathematics, there exists the Bayesian approach. Related to that, we know the Black/Litterman approach. In medicine and other disciplines, there are "evidence-based" approaches - what is your take on enhancing quantitative with qualitative information in a structured manner?
First, there is no way we can know what is the optimum portfolio. Estimation error means we have a distribution of portfolios that could be optimal.
Secondly: We can use resampling or bootstrapping to give us an idea of this distribution.
Thirdly: Choose a portfolio in this cloud of possible optimums that is line with your qualitative information. By the very nature of qualitative information, this has to be subjective.
Fourthly: Be prepared to have to defend this approach from people who think that it lacks rigour. When I've seen the arguments of such people I find that what is lacking is a rigourous knowledge of the statistical underpinnings of portfolio arithmetic.
Indexing portfolios
I saw this question on LinkedIn
Anyone know how I can reconcile the difference between two benchmarks?
I am trying to reconcile the returns of the S&P600 Citi Growth (-11.10% YTD) with the Russell 2000 Growth (-5.80% YTD). What I would like to find out is what fundamental and/or economic factors caused the difference in these small cap indexes. Any insight would be appreciated.
My response:
Embrace the difference!
What this difference reinforces is the arbitrariness of benchmarks. Fundamentally, we want to know a representative return of the small(ish) end of the stockmarket. Well we have a big question of definition - what do you mean by small caps? And what do you regard as a representative return. Because these questions are vague we should not be concerned if we get a vague answer - in this case a return of between -11.10% and -5.80%. Or maybe wider.
What it also shows is that if we want a passive small cap portfolio to reduce investment costs and tax, then having a tracking error limit of about 5% might be OK. Allowing your portfolio to passively drift away from your benchmark up to such a level will drastically reduce your costs, while still achieving your objective of having a return similar to the market segment as a whole.
More comment
This question is one whose kind comes up quite often in funds management and shows that the basic idea of indexation has lost its focus over the years. Instead of being a method for running a low cost portfolio its been turned, in many cases, into a way in which IM companies can show off how good they are by having a low tracking error. The final beneficiaries don't really want low tracking error, they want low cost. IM firms and consultants need something that they can sell and consult on, so they go for something you can easily measure and that sounds good, even if it's useless.
Anyone know how I can reconcile the difference between two benchmarks?
I am trying to reconcile the returns of the S&P600 Citi Growth (-11.10% YTD) with the Russell 2000 Growth (-5.80% YTD). What I would like to find out is what fundamental and/or economic factors caused the difference in these small cap indexes. Any insight would be appreciated.
My response:
Embrace the difference!
What this difference reinforces is the arbitrariness of benchmarks. Fundamentally, we want to know a representative return of the small(ish) end of the stockmarket. Well we have a big question of definition - what do you mean by small caps? And what do you regard as a representative return. Because these questions are vague we should not be concerned if we get a vague answer - in this case a return of between -11.10% and -5.80%. Or maybe wider.
What it also shows is that if we want a passive small cap portfolio to reduce investment costs and tax, then having a tracking error limit of about 5% might be OK. Allowing your portfolio to passively drift away from your benchmark up to such a level will drastically reduce your costs, while still achieving your objective of having a return similar to the market segment as a whole.
More comment
This question is one whose kind comes up quite often in funds management and shows that the basic idea of indexation has lost its focus over the years. Instead of being a method for running a low cost portfolio its been turned, in many cases, into a way in which IM companies can show off how good they are by having a low tracking error. The final beneficiaries don't really want low tracking error, they want low cost. IM firms and consultants need something that they can sell and consult on, so they go for something you can easily measure and that sounds good, even if it's useless.
Thursday, February 12, 2009
Falling behind
Why can't Australia be moving rapidly towards requiring companies to report in XBRL format?
See EDGAR report.
See EDGAR report.
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