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Another Partial Solution: Conditional Sharpe Ratio
Tuesday, December 13 2011 | 05:48 PM
|“What this country needs is a good five-cent cigar,” Thomas Marshall (Woodrow Wilson's vice president) once remarked. Updating the quip for 21st century finance might run as follows: Investors need a good risk metric. Alas, what's needed and what's available isn't usually, if ever, one and the same in the money game. The next best thing is tapping several flawed metrics that are flawed in different ways.
Last week I discussed one "partial solution" in the search for an upgrade to the nearly 50-year-old Sharpe ratio, the widely used but flawed measure of quoting risk premiums (return less a risk-free rate) per unit of performance volatility (standard deviation). As many critics have charged over the years, standard deviation falls well short of the ideal definition of investment risk. So, too, does everything else.
One big challenge is modeling what's known as tail risk, or the possibility—the virtual inevitability—that investment losses will exceed expectations implied by a normal distribution. Last week's look at one attempt at trying to anticipate non-normality was the modified Sharpe ratio, which incorporates skewness and kurtosis into the calculation. Another possibility is the so-called conditional Sharpe ratio (CSR), which attempts to quantify the risk that an asset or portfolio will experience extreme losses.
To understand CSR it's necessary to start with so-called value at risk (VaR), the much maligned metric that was (and still is) widely used and widely abused. At its core, VaR tries to tell us what the possibility of loss is up to some confidence level, usually 95%. So, for instance, one might say that a certain portfolio is at risk of losing X% for 95% of the time. What about the remaining 5%? That's where the trouble lies, of course, and trying to model the last 5% (or 1% for a 99% confidence level) is devilishly hard. Some analysts say it's simply impossible. Misinformed or not, conditional VaR, or CVaR, dares to tread into this black hole of fat taildom. For the conditional Sharpe ratio, CVaR replaces standard deviation in the metric's denominator.
As a recent research paper from Ibbotson Associates explains,
"CVaR is a comprehensive measure of the entire part of the tail that is being observed, and for many, the preferred measurement of downside risk. In contrast with CVaR, VaR is only a statement about one particular point on the distribution. Intuitively, CVaR is a more complete measure of risk relative to VaR and previous studies have shown that CVaR has more attractive properties (see for example, Rockafellar and Uryasev (2000) and Pflug (2000))."
The main question with CVaR is one of choosing a methodology for calculation. The standard approach—the parametric method—is to assume a normal distribution, in which case CVaR can be estimated with only three inputs: average (or expected) return, volatility, and a conventional assumption about distributions. Easy but fraught with caveats.
Fortunately, there are several alternative approaches for estimating CVaR. One is using Monte Carlo simulations, which come in a variety of flavors and assumptions. The basic version can be easily run in Excel. You can also estimate CVaR based on an historical sample. If, for instance, you were calculating tail risk for the S&P 500 through a CVaR prism, you would identify the extreme return outliers in the past and factor the data into your CVaR modeling. WIth a little bit of work in a spreadsheet, you can come up with a rough estimate fairly easily. More sophisticated analytics require programming in Matlab or R.
Readers at this point are probably wondering how much insight is offered in CVaR, and by extension the conditional Sharpe ratio. Probably less than its strongest advocates argue. The basic message in conditional Sharpe ratio, like that of its modified counterpart, is that investors underestimate risk by roughly a third (or more?) when looking only at standard deviation and related metrics. That's a critical message. The details get fuzzy once you move beyond that reasonable conclusion. One reason is that quantifying expected risk in the tail is a serious challenge and open to a fair amount of debate.
Indeed, you can't model uncertainty per se. Even when it comes to modeling the known unknowns it's still best to regularly repeat the following: no one risk measure can profile the true nature of risk in all its fury and variation. But we can try, if only to develop a deeper understanding of risk analytics' strengths and weaknesses. At some point, however, you're still flying blind.
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DO Fight The Fed
Wednesday, September 21 2011 | 11:07 AM
Vinny Catalano CFA
President & Global Investment Strategist,
BLUE MARBLE RESEARCH
|Today, Wall Street's Professional Investor Class (PIC) waits with bated breath for the Fed to provide words of comfort so that one of Wall Street's revered axioms, "don't fight the Fed", will deliver much needed relief to the beleaguered warriors of finance.
One of characteristic of the PICs that is useful to remember is that they are highly reliant on heuristics - rules of thumb that help frame the world into bite-sized analytical pieces. One of the heuristics that has worked from time immemorial is 'don't fight the Fed". For example, last year, around this time, a well-known hedge fund manager advised investors and traders of this well-worn axiom to great effect and result (stocks rose from the fall of 2010 into the summer of 2011). Unfortunately, while the monetary elixir did work its magic on the PICs (they bought stocks), it had little effect on the real economy.
Never sated, the ever-thirsty PICs are back at the don't-fight-the-Fed troff for another hearty slurp of monetary ease = higher risk asset values. From the PICs and Fed's perspectives, the economic rationale for this view is rather simple: Easy money = an increase in the value of risky assets = a positive wealth effect = increase demand = higher GDP (which then = higher wages, increased hiring, etc, etc). Hence, don't fight the Fed ALWAYS delivers. Or does it? And when it does, is the effect always the same under all conditions? Or are the results a product of the economic and financial times?
It may be a risky thing to go against such a dogma. After all, the four most dangerous words in the investment language is "this time is different". And to assume that more easy money will not produce the above listed outcomes is the speak those very dangerous words. Yet, if one believes we are in times that are truly different, particularly in the post WW II era, then perhaps it's time from some fresh perspectives.
Going against such a well-established dogma of day is also especially dangerous given the changed structure of the market. For, when the momo lemmings (who could care less what the drivers are or what direction the markets are headed, just along as stock prices move) jump on the market trend du jour bandwagon, the wheels get turning rather quickly.
Investment Strategy Implications
If you are going to go against a revered heuristic it is useful to have your own heuristic to counter the revered one. My heuristic is this: in a liquidity trap, the effectiveness of monetary policy is limited, at best. Moreover, monetary ease becomes even more limited when fiscal policy is contradtionary (i.e., expansionary austerity). These global macro forces are strong, pervasive, and global in scope.
So, the PICs may rejoice in what they hear today. And risk assets may rise - for a while. But the global macro forces at work can, and I believe will, overwhelm the monetary elixir the Fed will provide. And the PICs don't do global macro very well. (More on this point in a future blog posting.)
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A New Kind of Risk
Thursday, July 28 2011 | 08:52 AM
Chief Executive Officer & Co-Founder,
|While the global markets are preoccupied with how to account for obvious risks such as breaching the US debt ceiling, Greece default and their domino effects. There are many risks that are not even in the minds of many investors let alone being priced-in by the markets.
There is a real risk of potential cyber attacks targeting companies or attempting to paralyze the global financial systems as a whole to achieve radical political goals. The recent Sony and Lockheed cyber attacks illustrate the degree of vulnerability of even some of the most technologically advanced companies. Given the lack of comprehensive models of cyberspace and absence of general appreciation of the overall financial markets’ vulnerability to a widespread attack, investors don’t seem to be so much focused on the risks and pricing that in their valuation. Just the fear of it will create regulatory, operational and legal risks that will cost companies a great deal in both capital and management distraction. We are far from fully understanding and pricing of cyber attack risks and the possible implications for the overall global markets.
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Black Swan Hype
Monday, March 21 2011 | 03:01 PM
|I don’t know about you but I grow weary of being regarded as stupid by these “Black Swan” guys who use scare tactics to influence normally sane investors.
A Black Swan is the latest buzz word which is a metaphor that encapsulates the event to be a surprise with major impact. In the “old” days we used the term “exogenous event”. An exogenous event in the capital markets is a one-off variable that is not resultant from any of the usual market drivers such as earning releases, employment data and industrial production numbers. The exogenous event (in this case Japan) is an external event that is large enough to affect markets and because it is change that comes from outside any model or analysis, there is no way to anticipate the event
The black swan buffoons tell us “this time it’s different, something is wrong.” The idea here is to have you believe that what ever worked in the past, won’t work anymore. We are to reject traditional stock analysis and to fear the current environment because it always the wrong time to invest.
They will tell you that buy-and-hold is dead because the equity markets have delivered zero returns over the past twelve years, just like the 1968 – 1980 period. What they don’t tell you is that during these long congestive periods there is great opportunity because “the next big thing” can emerge from these periods. The next big thing that emerged from the 1968 – 1980 zero return period was the new economy and the related components. To-day start-ups like Intel Corporation, Cisco Systems, Inc. Microsoft Corporation and Apple Inc. are household names.
The current 2000 – 2011 zero return period introduced the global economy and the related commodity boom. I do believe the Black Swans which is a large waterbird found mainly in the southeast and southwest regions of Australia missed this great investment opportunity.
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The Biggest Headache For Groupon And Facebook Investors
Friday, March 04 2011 | 10:02 AM
TAVAKOLI STRUCTURED FINANCE
|Groupon makes its money by selling coupons for goods and services. It partners with local merchants. When you buy a coupon for a merchant's discount on Groupon, it reportedly takes a 50% cut in the U.S.
Groupon has had a few embarrassments. On Valentine's Day, FTD's flowers were priced lower than Groupon's "deals" and the online discounter had to apologize to customers. Moreover, merchants often put conditions and restrictions on Groupon discounts that dilute the value of the deal, similar to restrictions on redeeming air miles. Even so Groupon's valuations have ranged from $1.2 billion to $6 billion to $15 billion all in the space of a year. What's it really worth? More on that later.
Facebook is free and "always will be." It makes its money from ads and revenues from games (if users don't block them), albeit phone apps so far do not display ads. Michael Arrington at Techcrunch reported that Facebook is secretly building its own phone to control its own operating system. He noted that Li Ka-Shing is a Facebook investor, and he is an investor in the rumored INQ and Spotify phone project. While Facebook may remain free, it would have to figure out a way to get users to pay their phone bills.
Facebook has tremendous potential to exploit its 500 million users. In fact, one of Facebook's fundraisers is a genius at exploitation. Goldman Sachs, the Great and Powerful Oz of Finance (just don't look behind the curtain), has already opined on Facebook's value. In January 2011, it valued Facebook at $50 billion when it sought to raise $1.5 billion in Facebook financing.
Rich Teitelbaum of Bloomberg News reminded the financial world that Goldman Sachs Asset Management's anemic track record suggests that Goldman may not be the best go-to source for putting a value on an asset. Despite Goldman's public relations hype that it employs the "best and brightest," it trailed the average return of its peer group in every category. Goldman has an incentive to dangle a high valuation on Facebook in front of clients:
Jim Clark of Netscape and Silicon Graphics fame was irritated that Goldman wanted to fee stuff its Facebook offering with a 4 percent placement fee, a half percent expense fee, and a snatch-back of 5 percent of investors' potential profits.
A few months earlier, Clark had invested in Facebook through another financial firm at a lower price, and the other firm wouldn't potentially gouge him with Goldman's 5 percent pleasure-of-your-company tax. "I don't think it's reasonable," Clark told Bloomberg. "It's just another way for [Goldman] to make money from their clients." The question remains whether Clark bought his stake at a reasonable price.
"Blankfein Flunks Asset Management as Clark Vows No More Goldman," by Richard Teitelbaum, Bloomberg News, January 24, 2011
In January 2011, SharesPost Inc. valued Facebook at $82.9 billion on the secondary exchange. Whatever price the market will pay today, one has to be concerned about what it will pay tomorrow. Even if the future value of Facebook is say, $4 billion, Goldman will rake in fees.
Both Facebook and Groupon became successes because they are web based networks that required few management skills, minimum capital to start, and there were no barriers to entry. That is also their biggest problem. The ugly truth is that no one can tell you what they are worth as businesses.
Groupon's successful-so-far revenue model is its curse. It's both trying to hold its position in "established" markets, and it's trying to expand. The problem is that web users in other countries have noticed Groupon's success and the fact that Groupon has been paying high premiums for local established discounting web sites just to get at the client distribution lists.
Groupon's competitors are both buying sites for the same reason as Groupon, and local entrepreneurs can easily copy Groupon's business model. It seems all it takes is a good web developer, a two-page merchant agreement, and an accounting firm that can handle the taxes as a site expands internationally. Groupon may have a head start, but it has no long-term competitive advantage. That puts its margins, its market share, and it's ability to expand and hold its position in new markets at risk.
Smart investors look for highly skilled managers in industries with a long-term competitive advantage in a stable industry run by decision makers with a "here-today, here-forever" mentality. Between Groupon and Facebook, it seems Facebook has the better chance of making a case, but it hasn't made one so far.
Facebook seems to be thinking of ways to create a loyal user base by penetrating deep within its user base. It certainly has a shot, but it is unclear whether it can maintain a competitive advantage.
Users are fickle, and young users will gravitate to the next exciting new thing. The rapid success of Catherine Cook's myyearbook.com has to give investors pause. She started the site 6 years ago as a 16-year old high school student with a $250,000 investment from her brother, and the site is valued at $20 million. While it's no threat to Facebook, it has a fresh look, is responsive to users, and offers new spins such as allowing users to buy each other gifts and "lunch money."
Investors may wonder when the next bright young kid will eat Facebook's lunch and make it look like a site for old fogies. Facebook may adapt, but it would do itself favors by disclosing its revenues, and how it plans to face up to potential competitors.
Note: This post originally appeared in the Huffington Post.
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