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OTHERS OF NOTE
Keeping Investors in the Dark About the Real Risk
Debt increases risk, and risk increases volatility.
As such increases in debt typically cause increases in volatility.
But that is no longer the case as a recent report from McKinsey showed debt has increased $57T since the Financial Crisis yet volatility has been at historic lows during this period.
Risk to capital in actual fact has never been greater! Only recently has the VIX begun to rise.
WHAT YOU NEED TO UNDERSTAND
DEFINITION OF 'ALPHA'
1. A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund's alpha.
2. The abnormal rate of return on a security or portfolio in excess of what would be predicted by an equilibrium model like the capital asset pricing model (CAPM).
INVESTOPEDIA EXPLAINS 'ALPHA'
1. Alpha is one of five technical risk ratios; the others are
- Standard deviation,
- R-squared, and
- The Sharpe ratio.
These are all statistical measurements used in modern portfolio theory (MPT). All of these indicators are intended to help investors determine the risk-reward profile of a mutual fund. Simply stated, alpha is often considered to represent the value that a portfolio manager adds to or subtracts from a fund's return.
A positive alpha of 1.0 means the fund has outperformed its benchmark index by 1%. Correspondingly, a similar negative alpha would indicate an underperformance of 1%.
2. If a CAPM analysis estimates that a portfolio should earn 10% based on the risk of the portfolio but the portfolio actually earns 15%, the portfolio's alpha would be 5%. This 5% is the excess return over what was predicted in the CAPM model
TOTAL & RISK ADJUSTED RETURNS
The concept of risk for hedge fund managers is a constant concern as they focus on Total returns and Risk adjusted returns.
Most investors could not care less about risk adjusted returns. Dominique Dassault via GlobalSlant.com does
The holy grail of risk metrics is the Sharpe Ratio. The most interesting precept of the Sharpe Ratio is that it treats volatility as random…both upside and downside volatility. No way to predict it in either direction so both directions are assigned the same discounting value. Basically, according to Bill Sharpe, all volatility is a penalty against your performance.
Still, in a perfect world, what if most of the volatility experienced by a portfolio of equities was actually favorable? So rare…if not impossible…but still at least worthy of consideration. And so the Sortino Ratio [or the Gain/Pain Ratio] was born…essentially, it is exactly as the Sharpe Ratio but stratifies favored and un-favored volatility. Favorable volatility is not penalized. Unfavorable volatility is scored as a legitimate demerit. It has always seemed fairer to me.
Naturally, both ratios are relevant and higher values for both measurements reflect better risk-adjusted returns. And portfolio managers realize that, no matter the ratio, both need to positive…or you are losing money. However, given full investment of capital, the Sharpe Ratio can be strongly positive yet still not offer high absolute returns. Conversely, if your Sortino Ratio is high, you are probably delivering very strong absolute returns…again, assuming full investment of capital.
Given all of this…What is a good numerical value for both ratios? Generally, over time, any value > 1.5 is pretty good and numbers > 2.0 are stellar. Be advised the data may vacillate, a little bit, based on the time frame used in your calculation i.e. weekly or monthly.
Recently I constructed a model that required one, three and five year Sharpe Ratios for the S&P 500. I also decided to include the Sortino Ratio. Prior to the results I hypothesized that the numbers ought to be pretty impressive given the endless equity “bull” since March 2009 but I was still curious to get the exact data. Plus, a weekly price chart of the S&P 500, since 2009, visually reflects the anomaly of very limited draw-downs in the context of extremely strong returns. The calculations are as follows and as Mrs. Doubtfire once said…“Effie…Brace Yourself”.
1 Year = 1.37
3 Year = 1.86
5 Year =1.0
1 Year = 2.65
3 Year = 3.41
5 Year = 1.69
Collectively, these numbers are clearly impressive but even more so in that they are calculated from a passive, long only strategy. This is a hedge fund manager’s worst nightmare as, for five years, most “hedging” has proved to be only performance degrading.
Furthermore, the Sortino Ratio data are nothing short of staggering.
What they really say = Plenty of Gain with Very Little Pain.…and it really is unsustainable if only because it has become much too easy to generate positive returns with very little effort, pain or savvy.
It actually seems, at times, as though there is this mysteriously large buyer that suddenly appears whenever the equity market most “needs it”... and the subsequent buying is so aggressive and so desperate... not the style of the mostly steady “hands” I personally know.
It just seems too good to be true and the Sortino Ratio numerically reflects that belief. Plus, we all know that the economic fundamentals are not as smooth as the weekly or monthly charts of the S&P 500 would suggest.
Remember that equities typically offer the most risk of any asset class... not the lowest risk as the above data set suggests.
DERIVATIVES AS ALPHA GENERATORS
Derivatives: No Longer Used For Hedging But Exclusively For "Alpha Generation" 02-14-15 Zero Hedge
Citi recently surveyed 43 banks, 29 asset managers, and 31 hedge funds regarding their outlook for the credit derivatives market in 2015, the consensus was that “there seems to be plenty of room and enthusiasm to use derivatives to take leveraged risk." Phew: for a minute there it looked like leveraged risk taking with derivatives might go the way of the Dodo in the post-crisis world, making Bruno Iksil the last great example of how much fun one can have stomping around in off-the-run CDS indices with depositors’ money.
It’s also comforting to know that among those Citi surveyed, the general consensus was that
"...there seems to have been a shift from using derivatives as a hedging tool, to using them more for alpha generation [as] most products are now used more for adding risk and directional views."
So investment professionals and sophisticated market participants are quite eager to take leveraged risk with derivatives with an eye not towards “hedging” (i.e. mitigating risk), but towards “alpha generation” and expressing “directional views” (i.e. gambling). In fact, nearly two-thirds of those surveyed listed either “alpha generation” or “adding risk” as the primary reason for trading single-name and index CDS:
For credit tranches, the combined figure was 82%:
The takeaway: banks and “sophisticated” investors are increasingly eager to take leveraged risk with derivatives in order to make directional bets on credit spreads. That certainly sounds like a pre-crisis mentality to us and it naturally won’t end well if the (re)proliferation of risk-taking via these instruments manages to embed an outsized amount of counterparty risk in the system.
Finally, in what surely was an effort to furnish readers with a bit of comic relief, Citi asked respondents if they “were concerned about investors taking more levered risks using derivatives” (here’s where one can gauge the extent to which those we entrust with our investments took the lessons of 2008 seriously). The results:
WHAT DOES THIS REALLY MEAN?
The following chart, courtesy of Citigroup, demonstrating the liquidity cliff i.e., the impact of a liquidity bubble on price and risk, is so mindbogglingly simple, it is no wonder that virtually nobody gets it.
As Citi observes, all a liquidity tsunami does for credit, as well as for equity, is to perpetuate the illusion of maximum pricing while shifting the risk curve to the point where any deviation from "perfection" - or loss of faith in the liquidity or its providers (as in central banks who in 2015 are finally going "all in") will ultimately lead to an instantaneous waterfall in price.
Which also explains why lately the exchanges have all been practicing how to most efficiently shut down when the "waterfall" moment arrives.
Because if there is no market, one simply can't sell.
No Obligations. No Credit Card.
Gordon T Long
Publisher & Editor
Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that you are encouraged to confirm the facts on your own before making important investment commitments.
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