Finding Alpha

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
• Im 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 gt economics gt
  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 Fishers Only Three Questions that Count
• small stocks were in a depression in the 1980s
• Eugene Fama

20
Everyone Benchmarks

• I visualized my grief if the stock market went
  way up and I wasnt in itor 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 peoples 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
• Dont take risk investing in above average
  volatility assets within any asset class, unless
  its a search for a comparative advantage
• Dont risk adjust returnsJust like derivatives!