Tactical Recommendations

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Tactical Recommendations

• Eric Falkenstein

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CAPM does not work

• Higher vol generally lower return
• ? avoid high volatility/beta stocks!

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Minimum Variance Portfolios

• Minimize the variance of subsets of popular
  indices
• Lower vol, dont lower return
• Robeco, Unigestion, MSCI have minimum variance
  products
• Haugen and Baker (1991), Jagannathan and Ma
  (2003), Schwarz (2000), Clarke, DeSilva and
  Thorley (2006), Blitz and van Vliet (2007)

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Minimum Volatility Portfolios

• Take subset of popular stock indices
• Find minimum variance weightings
• TT covariance matrix
• Use Jones heteroskedasticity consistent
  principle components algorithm (Jones 2002) to
  get factors
• This produces the TK set of factors, F
• regress each security against these factors to
  get the factor sensitivities for each security,
• Create new covariance matrix

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MVP Construction

• Find weights with added constraints
• No shorts
• Cap on weight of 2 for SP500, 4 for other
  indices
• Stocks found generally at max limit for longs
• Redo each 6 months based on daily data from prior
  year

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Indexes are not near 'Efficient'
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Total Return for MVPs vs. Indices
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Beta Arbitrage

• If CAPM does not work, and equity premium is
  positive
• Long 3 units 0.5 Beta stock, Short 1 unit 1.5
  beta stock
• Zero Beta, long 2 units of stock!
• Better if long beta has lower returns

E(R)
Rf
1.0
Beta
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Beta Strategies
Data from 1962-2009, monthly returns, annualized
used top 80 of NYSE market cap (about 1500
stocks today)
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Tracking Error to Beta Portfolios
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Beta Arbitrage Beta0 Strats
Each strategy has a beta of 0, and is dollar long
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Tracking Error to Beta Arb Portfolios
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Tracking Error to Beta Arb Portfolios
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Beta Arb Summary

• Benchmark SP500
• Sharpe 0.27
• Beta 1.0
• Return 10.3
• For retail investors Beta 1.0 portfolio
• Sharpe 0.37
• Beta 1.0
• Return 12.6
• For business school grads Beta 0.5 portfolio
• Sharpe 0.51
• Beta 0.57
• Return 11.5
• MVPs have similar dominance to low beta focus
• For finance professor Long Beta 0.5 short SP500
  index
• Sharpe Information Ratio 0.39
• Beta 0.0
• Return 3.3risk free rate

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Investment Advisor

• Assume people want to do what everyone else is
  doing
• Appealing asset allocation based on consensus,
  not volatility
• Sell idea of trading envy for greed
• MVPs
• Beta Arbitrage
• Will deviate from the benchmark

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Seeking Alpha

• If your investments success is unaffected by
  anything skill you have, you are gambling
• Eg, lottery tickets
• Sharpegt1 strategies are not sold in mass
• People only sell to a general audience
• Low alpha (eg, index funds, MVPs)
• Negative alpha (Sturgeons law)
• High Alpha takes moderate intelligence, high
  initiative
• Hate, but dont fear, failure.
• Optimal search for ones niche implies failure

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Finance is mainly about people, not math

• Most value-add in finance about brand, scope,
  scale, relationshipsnot trenchant forecasting
  ability
• Realize people are engaging in a repeated game,
  looking for a niche
• Dont be too cynical
• Liars Poker everyones a fraud, investing is a
  scam
• Must accept a certain level of alpha duplicity
• Big company standard politics, need to be
  popular with customers and colleagues, not right