Thought Bubbles from the Deep

[craft]

What portfolio should you hold if you want a basic exposure to the Australian market as a source of equity risk premium?

The benchmark indices are arbitrary in the sense that a large bank is held at large weight simply because it is big. Had a major buyer come in and taken a strategic chunk, reducing the float available in the bank, free-float adjusted exposures would fall. Nothing changed in the operating environment. The benchmark indices are an indication of aggregate holdings available to public investors who do not take strategic chunks of companies. It will produce returns better than the average of such investors due to the presence of frictions. An odds on strategy to be above the money-weighted average of investors is simply not to try to beat the rest. Add tax considerations to this and, depending on the rate and whether you are a trader/investor, these frictions become very meaningful, although a few percent can seem trivial to many on this site...it isn't over time and considerably raises the bar to argue against a pure index approach. Nonetheless, is there a better starting point?

Risk parity is a concept which was brought into popularity by Ray Dalio of Bridgewater Associates, the world's largest hedge fund manager. The idea has evolved to, kinda sorta, build a portfolio whose main components had equal risk contributions (proportion of overall volatility). This was a set and forget technique which required no further judgment about the future performance other than volatility and correlations. That is, no specific return forecasts are made. Dalio's idea was to apply this to a trust for his family after he had passed away...hence no forward looking judgment on returns, beyond estimation of risk.

By doing this, the portfolio is well balanced in terms of risk contributions. Each stock in the portfolio contributes the same amount to the volatility of the portfolio. Risk parity. This takes into account volatilities and correlations, which have been demonstrated to be much more stable in estimation than for return forecasts for such things.

If all banks are essentially the same, adding another bank to the portfolio will see the exposures redistributed amongst all the banks, not an addition to the overall weight. That seems pretty sensible.

In other words, the risk parity portfolio does the best it can with the stocks available to build a widely diversified portfolio. One whose exposures are as widely spread as possible given risk estimates. The very diversified nature of the portfolio helps to protect against estimation errors. It takes into account things like a bank's performance tends to be rather similar to the environment for discretionary consumer behaviour.

Based on data to late last year, the risk parity portfolio for Australian equities vs the ASX 200 index had the following GICS exposures (I have broken up Financials into finer definitions given their dominance in the Australian market):


View attachment 65719

It has much less exposure to banks, preferring to spread the exposure more towards consumer discretionary stocks and other cyclical sectors (eg. IT and Industrials). The more stable nature of healthcare stocks (in general) sees them being given more weight. Interestingly, the exposure to materials remains fairly in line. I think it is clear that this portfolio is more diverse and possibly a more sensible way to gain exposure to the Australian market components.

The portfolio spreads its exposures differently from simply equally weighting the components. However, the broad exposures do produce a significant bias away from the largest companies. Although the exposure to small capitalisation companies is much larger than for the index, the diversification produced by this portfolio reduces the overall expected volatility relative to the index. By dramatically reducing the exposure to large capitalisation stocks, company specific blow-ups are less impactful and pretty much no company specific event is going to hurt that much.

I believe this concept is a useful consideration in determining a suitable departure point for a portfolio. The expected range of performance of this portfolio relative to the index is +/-2.6% on a 1-std devn basis (ie. within this range two-thirds of the time over a year). This means that variation in physical exposure via the use of index futures is viable. There are also some rebalancing benefits which can be expected. If you think that all stocks in the index are expected to have the same geometric return (if you started them all at $1, they will just wiggle around like dust in the air, which has a small breeze, as the prices evolve. None is particularly destined to shoot away to either extreme), the RP portfolio is expected to produce about 1.4%per annum more from rebalancing effects (it won't get this due to frictions, but an edge will remain).

Unless volatility has some utility as a 'true & thorough' measure of risk is it any better then straight equal weight? Seems like you have to settle the volatility = risk debate before you can really decide if quantitative risk parity is right for you.

I'm all for risk parity within my portfolio but the risk assessment is perception/judgement based- I'm not smart enough to be able to code and quantify risk.

 

[sinner]

Unless volatility has some utility as a 'true & thorough' measure of risk is it any better then straight equal weight? Seems like you have to settle the volatility = risk debate before you can really decide if quantitative risk parity is right for you.

I'm all for risk parity within my portfolio but the risk assessment is perception/judgement based- I'm not smart enough to be able to code and quantify risk.

It depends on the desired goal to be achieved but the work of Eric Falkeinstein is pretty convincing in this regard,

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1103404

This is just a snippet of table 6.1 (PDF version of the paper available for free at the link above) but you can see it ranks quite well as a standalone quantitative measure amongst a universe of stocks in predicting bankruptcy (high vol firms more likely to go bankrupt) compared to much more complex measures.


Falkenstein is no longer blogging but the pages of his "Falkenblog" will provide an enlightening read about some properties of volatility and whatnot.

Most modern corporate bankruptcy models at least include vols as an input.

 

[DeepState]

Risk Parity

Thanks for your considered expansions.

Volatility is a statistical construct as a measure of risk. It has nice maths properties which help to make them popular and give some sensation that investment is sort of like physics. False comfort there. It's not the kind of risk which matters ultimately (having insufficient funds to meet your objectives/live adequately) in investment. It is just a proxy.

As a proxy, it is very likely to be better than the alternative of assuming that all stocks are equally risky (Buffett definition). It is not perfect. There will be exceptions here and there. Some ultra-speculative stock might be a 10x. In retrospect it wasn't dangerous or speculative at all....

Some super-safe investment, like AAA tranches of CDO securities in 2008, turned out not to be so safe.

The shortcomings of these proxies mean that we should not push models which rely on such constructs. One good thing about RP is that it is fairly robust to errors in estimation.

If you've got an excellent way to estimating risk per Buffett (including systemic risk to boot), you should definitely use that instead. Buffet is clearly a genius. However, even Buffett prefers an equity index fund for his wife when he passes on. Risk Parity is probably more sensible than that given the arguments made by Dalio. RP is a departure point for me (actually, there is a modifier which draws on - can you believe it - Falkenstein's PhD dissertation). If I knew nothing else but prices or easily extracted fundamentals, what could I calculate in a minute to create a reasonable portfolio of equity securities? RP would do alright, in my view.

 

[sinner]

Some super-safe investment, like AAA tranches of CDO securities in 2008, turned out not to be so safe.

As a contextual note, this was certainly captured by volatility measures for those paying attention to timeseries published by MarkIt and others:


(h/t Atlanta Fed)

As you can see constraining the above timeseries by volatility would have been significantly less damaging to overall equity than relying on either S&P or Moody ratings. Of course, at the time, nobody paid any heed whatsoever to those paying attention and we were largely dismissed as quacks (try being the son of a macroeconomics professor and convincing your father that S&P rated AAA is dog****)

can you believe it - Falkenstein's PhD dissertation

hehe! As his work is quite compelling I can absolutely believe ...consider sending the man an email to let him know his work has had impact, as he has always had a bit of a chip on his shoulder about not receiving recognition/achieving impact.

what could I calculate in a minute to create a reasonable portfolio of equity securities? RP would do alright, in my view.

Certainly when it comes to selecting assets within an asset class (e.g. ASX stocks, or US credit) volatility seems to be a more robust measure than selecting across asset classes, as Buffett noted of less volatile currency based assets vs more volatile equity based assets. I am not sure that mechanism is fully explained, at least I certainly haven't witnessed any satisfying explanation.

 

[qldfrog]

you mentioned it in the initial question but are you not afraid the imbalance in the asx would make some of your diversification more like a bet on small cap stocks?
look at IT stocks in Australia or even retail, the picture would be so different in Europe or the US but no apple/IBM, ford/GM here, there is a stranglehold of the few big 10 or so and then not much and the risks on these smaller caps becomes separated from their respective fields.
I do not know much there but the Aussie market may not be the best place for such strategy?

 

[DeepState]

you mentioned it in the initial question but are you not afraid the imbalance in the asx would make some of your diversification more like a bet on small cap stocks?
look at IT stocks in Australia or even retail, the picture would be so different in Europe or the US but no apple/IBM, ford/GM here, there is a stranglehold of the few big 10 or so and then not much and the risks on these smaller caps becomes separated from their respective fields.
I do not know much there but the Aussie market may not be the best place for such strategy?

The ASX 200 is so concentrated into the top 20 stocks and those top twenty stocks are, in turn, so concentrated into a small number of drivers that it might be better to say that the index is a massive large cap tilt away from something sensible and representative of a balanced equity market exposure.

Having said this, I referenced Falkenstein previously. There is something to be said about not tilting into heaps of high spec companies, even if the diversification maths works out.

The ASX is over-concentrated and has a source of earnings which do not represent something which I could call representative of an economy which I participate in. This is partly addressed via RP. However, RP brings exposures to other things which need to be contained. These may include aversion to the kinds of things you are possibly referring to above.

 

[sinner]

you mentioned it in the initial question but are you not afraid the imbalance in the asx would make some of your diversification more like a bet on small cap stocks?

The answer to your question is not clear cut, it depends entirely on a variety of factors, such as lookback period, rebalancing frequency and date, maximum allocation (e.g. using leverage or not), and long only vs long/short. Most risk parity models are examining not just vols but also in conjunction with correlation, so a lot of crap gets filtered out as low utility in diversification sense.

FWIW Bridgewater Allweather is long only, while Bridgewater Pure Alpha is running a long/short book (both at 200% allocation IIRC).

It's been a while since I looked, but from memory most smalls are more volatile and higher pairwise correlation than larges on the ASX, probably some exceptions like Dominos.

 

[systematic]

Ad-hoc comments:

I like the Buffett quote. Learned the same from David Dreman a long time ago and still agree with it. I like Buffett's, "I'd much rather earn a lumpy 15% than a smooth 12%"
I'm a little more tempered now. I'm almost financial planner like (a moral one!) in the way I like to consider that it really depends on people's goals; what they want to acheive. Smooth returns (Buffett's, 12%) might be someone's goal. Avoiding excessive drawdown's might be someone's goal. Without the motivation of running a fund (with the goal of high returns), if I had a certain amount of money, as an individual investor, my goals would probably change too.

On the portfolio thing, equal weight is just fine by me (or the 1/N system for the cool nerds). Just haven't seen anything else in the academic papers to inspire otherwise. An agnostic equal weight just does a good job.

Back to the question though, I'm a little confused. DS, you initially asked, '"What portfolio should you hold if you want a basic exposure to the Australian market as a source of equity risk premium?" Without considering why or whether one should want an exposure to the Aussie market...a simple cap weighted index will do the job. It will do just that - give you a basic exposure to the Australian market. Comments about the Aussie market being top heavy are irrelevant, as the characteristics of the market, whatever they are, are what they are (if that makes sense). If the Australian market is top heavy, it's top heavy...and a decision to have a basic exposure to that market will (and should) reflect that. An exposure to Australian industry or the Australian economy or whatever might be a different matter. But this is about an exposure to the listed equity market in Australia. If someone is asking me for a basic exposure to Australian public stocks, I'd have to answer something along the lines of, 'you can't get much more basic exposure to the market than something like a cap weighted asx300 or somesuch index'
Going with an equal weight index is simply going to give you a non-size weighted exposure to the market, and would be just as fine. At the end of the day, there's not going to be a massive difference, anyway.

Anyway - just random thoughts really. I'm finding this thought piece (is that what you call a thread within a thread?) quite interesting. Keep the posts coming, everyone.

 

[DeepState]

1. On the portfolio thing, equal weight is just fine by me (or the 1/N system for the cool nerds). Just haven't seen anything else in the academic papers to inspire otherwise. An agnostic equal weight just does a good job.


--


2. Back to the question though, I'm a little confused. DS, you initially asked, '"What portfolio should you hold if you want a basic exposure to the Australian market as a source of equity risk premium?" Without considering why or whether one should want an exposure to the Aussie market...a simple cap weighted index will do the job. It will do just that - give you a basic exposure to the Australian market. Comments about the Aussie market being top heavy are irrelevant, as the characteristics of the market, whatever they are, are what they are (if that makes sense). If the Australian market is top heavy, it's top heavy...and a decision to have a basic exposure to that market will (and should) reflect that. An exposure to Australian industry or the Australian economy or whatever might be a different matter. But this is about an exposure to the listed equity market in Australia. If someone is asking me for a basic exposure to Australian public stocks, I'd have to answer something along the lines of, 'you can't get much more basic exposure to the market than something like a cap weighted asx300 or somesuch index'

Going with an equal weight index is simply going to give you a non-size weighted exposure to the market, and would be just as fine. At the end of the day, there's not going to be a massive difference, anyway.

Thanks for your observations.

1. 1/N has beaten the relevant cap-weighted index in just about every jurisdiction over meaningful time periods - except for Australia (last I looked). Really weird exception when you see it. Need to ask yourself why that might be the case in Australia....

2. I have not expressed this accurately. You are quite right in terms of questioning the consistency of what I wrote. It is not consistent.

I meant to say that I seek a broad exposure to the equity risk premium available from stocks listed on the ASX. Though not strictly expressed, I also wish for this to be somewhat more balanced than exposures to banking and resources profits being some large figure as I am not a major consumer of these services. There is a concept of trying to get a broad exposure to the economy with half an eye on the nature of consumption.

Risk Parity helps to achieve this by spreading risk around. It is an advancement on equally weighting because it adjusts this concept for differences in risk/vol and makes allowance for correlations. It is essentially a quant version of equally weighted. Equal risk weighting. It's not a big step to take and, for me, not altogether too controversial.

You are right in that it is not a massive difference. The tracking error between an equally weighted index and the index is estimated at 3.2% [ie. on 2/3rds of rolling 1 year periods, the performance of the index and an equally weighted portfolio is likely to be +/- 3.2%].


---

As for papers, a good place to start is Clarke, DeSilva and Thorley (2013), "Risk Parity, ...", Journal of Portfolio Management, Spring 2013. These guys were the pioneers in implementing low-volatility portfolios. Key chart is below.



Focus on the 'X's as these are the geometric returns. RP is just a more sensible version of EW. The computation takes a fraction of a heartbeat, so the cost is negligible. They are both clearly superior to the index (at least over this time period and universe - US market). In the case of RP, this benefit was obtained with only about 1% more risk/vol.

 

[DeepState]

What happens when:

The actions of central banks are intended to support financial markets (to the point of bubble creation) in order to stimulate the real economy [tick]

The economy does not fire-up anywhere near as much as hoped [tick]

More stimulus is added [tick]

The economy does not fire-up anywhere near as much as hoped [tick]

More stimulus is added [tick]

The economy does not fire-up anywhere near as much as expected [tick]

Strong evidence emerges that China is slowing and the CCP limits of control are laid bare in the form of the stock market gyrations and capital account drain (despite a supposedly closed capital account)...imagine how confident we should be about their ability to handle a mark-to-market on their debt [tick]

China sneezes and the world catches a cold [tick]

CB Governors say we will do whatever it takes to keep things flowing and there is no limit to their tools or willingness to use it [tick]

Yet they or other members of their decision committees (or other places like the RBA) are saying that monetary policy has reached is useful limits and further stimulus is likely to be a riskier path to take going forward due to the formation of asset bubbles and the concern this causes to the economy. [tick]

And Japan goes negative...pushing out the date of when it thinks that things will be alright again to a timeline that says they haven't taken a step forward since all this began [tick]

It's markets rally and currency drops as hoped...[tick]

....but this is no longer sustained as in previous jumps...[tick]

...and the price of gold quietly sneaks up...[tick]

...and the price for credit keeps rising...to levels approximating the days when the EU was fragmenting and Whatever It Takes was doing the rounds. [tick]


....and the cracks in the belief that these huge props to the state the world can do the job widen enough...

Where is this tipping point?

I do not like what I am seeing. The Emperor is looking less well dressed. Can an economy really function when direct investment is undertaken by government and/or the central banks and investment returns are so low that private citizens won't bother saving much as there is no benefit to it? Because that it the natural limit of where all this monetary support goes.

This is not a prediction of the end of the financial system etc. However it is incredible how much rides on the belief that the CB actions will bear fruit. And for that to happen, a key requirement is that the belief is sustained. Yet the evidence is increasing that the belief may be unjustified.

I am waiting for the day when the governors of the major CBs are on some stage with Lagarde holding hands in a show of solidarity like Paulson, Geithner, Bernanke...did in the midst of the GFC. For them, they had a full war chest and bazookas. This time around, the bazookas have been fired. If that stage show happens, it's likely a sell this time around.

 

[sinner]

What happens when:

Hi DS,

All I could think while reading your checklist was "well, actually, what has changed?".

Things aren't simply rolling over from good to bad. Much more simply, cracks are re-appearing in the wall that we have papered over repeatedly since I was just a kid, exactly as they are want to do when the underlying problems are not addressed.

If that stage show happens, it's likely a sell this time around.

Merely looking to the recent past for direction may confuse one into suboptimal choices. In the next crisis, being an owner of corporate capital might be a much better option than going to cash. A (nominal) price crash is not always the inevitable outcome.

Statement A:

CB Governors say we will do whatever it takes to keep things flowing and there is no limit to their tools or willingness to use it

Statement B:

Yet they or other members of their decision committees (or other places like the RBA) are saying that monetary policy has reached is useful limits and further stimulus is likely to be a riskier path to take going forward due to the formation of asset bubbles and the concern this causes to the economy.

Prices heading towards the top right quadrant of the chart doesn't necessarily imply a bubble. If real value of currency is declining then all you are seeing in such a chart is the effect of dilution. In that light, statement A is far more congruent with statement B than might appear at first glance. FWIW I definitely believe the CB Governors when they make statement A.

This is not a prediction of the end of the financial system etc.

Nor does such a prediction make sense unless one truly believes that the global credit economy will subject itself to a global deflation. I for one think the opposite outcome makes much more sense and with higher probability (as I'm sure you've gathered by now .

The financial system will of course be saved as one of humanities greatest inventions, at the expense of something relatively unimportant: the currency unit.

Please forgive in advance the long snippet pasted below (from http://fofoa.blogspot.com.au/2011/04/deflation-or-hyperinflation.html)

Rick Ackerman's somewhat-myopic focus is on home mortgages as the lynch pin that will keep this worthless, symbolic token valuable while you toil on the chain-gang working off your debt of worthless tokens. So let's take a look at the larger picture to gauge the strength of this pin and the stress it must endure.

Total US mortgage debt is a little over $14 trillion. That number includes you and your neighbors. Of that $14 trillion, about $6 trillion sits on the balance sheets of banks and $9 trillion has been packaged and sold to savers like pension funds. Of that $9 trillion held by savers, about $5 trillion is guaranteed by the US government.

So here's Rick's lynchpin that's going to keep all of you indebted homeowners honest: $14 trillion - $5 trillion guaranteed = $9 trillion. And that $9 trillion lynchpin is so powerful because it is held by politically connected and powerful banksters and pension funds, or so they say. Now in a minute I'll tell you why these two groups would rather have all that debt printed and the cash handed to them than to watch even 20% of you default on your mortgages. But first, let's step back and take a wider look at what might be exerting shear stress on this supposed lynch pin.

Total worthless token debt in the US, both public and private, is around $55 trillion, four times as big as that backed by physical real estate. If we add in the government's unfunded liabilities (which definitely apply shear stress to the dollar's lynch pin), that number comes in around $168 trillion. And that is simply the promises to deliver worthless, purely symbolic tokens, at some time in the foreseeable future, emanating from within the United States. Meanwhile the US produces enough "goods and services" (loosely defined) every year to be purchased by 14 trillion of these purely symbolic tokens at their present level of purchasing power. And with a trade deficit of around $500 billion per year, it appears the US is consuming roughly 103.5% of what it produces every year, in real terms.

So in real terms, that is, in terms of the dollar's purchasing power as it stands today, it would take, let's see… $168T/($14T produced - $14.5T consumed)= x years… hmm… somehow it's going to take us negative 336 years to deliver those promised dollars at today's purchasing power. Remember I said this debt would be "worked off" in the past, without the use of a time machine I might add? Well here you go””past surplus labor foolishly stored in dollars and dollar financial instruments and their derivatives will be tendered. Of course the deflationists want you to know that we will be forced to reduce our consumption to below our production in order to pay those off. And once again, they are correct, though not in the way they think.

Reducing consumption means reducing your standard of living. Some call it austerity. But with forced austerity also comes the competition to avoid reducing your standard of living. And herein lies the inevitability of US dollar hyperinflation.

You see, those Power Elites that Rick thinks are going to support the dollar and its $169 trillion burden (excluding derivatives) simply to make sure you'll work off your $9 trillion dollar mortgage at today's purchasing power are the same ones that will resist personal austerity measures the most. And as all good deflationists know, you simply cannot resist the irresistible without breaking something. And what they will ultimately break in their competition to maintain lifestyle is the value of the dollar, which will actually break quite easily due to the mountainous (think: landslide) shear stress applied to it right now.

Now let's go back to those "banksters" that, along with the politically powerful pension funds, are part of the Power Elite that are going to keep the dollar strong enough so that your mortgage isn't hyperinflated away. Remember, this is roughly $6 trillion, or 3.5% of the dollar's debt problem, that is still sitting on the balance sheet of banks, yet gradually being absorbed and/or guaranteed by the Fed and/or the US government.

This is simple logic: Do you think they'd rather offload that debt onto the Fed's book in exchange for full cash value? Or would they prefer to hold onto those notes while you struggle to pay them off in symbolic tokens over the next 25 years? How about this: Is it better for the health of the bank to take possession of the houses (and then have to sell them) that roughly 20% of the troubled homeowners are walking away from? A 2009 jingle mail study showed that close to a fifth of troubled mortgages in the U.S. involved borrowers who were strategically defaulting. That represents roughly a 10% hit to the asset side of the banks' balance sheets. Yet the banks' liabilities (deposits created when the loans were originated) remain, fully insured by the FDIC which has no money.

Through the magic of commercial bank double-entry bookkeeping, the banks' balance sheets are actually not exposed to decreases in the purchasing power, or present value of purely symbolic, completely worthless token dollars. They are, however, exposed to decreases in the value of their assets and to the risk of default that flows from deflation. Deposits are nominal liabilities that remain when assets deflate. So supporting deflation would be, to a bank, like suffering a masochism fetish.

Rick thinks the banks will defend their assets by keeping the dollar strong. But that only keeps their liabilities that much harder to meet while the effects of deflation tend to shrink their assets making it even harder still. Ignoring the dollar for a moment, and the flaw in Myers' dictum, what happens to a bank's balance sheet if all of the loans are defaulted at the same time? Or if the asset value of all of their collateral collapsed at the same time? It would have precisely the same impact. So would a mixture of the two. The banks have and are experiencing precisely this type of squeeze. How has their "guardian angel" the Fed responded so far?

Rick Ackerman's view of the banks' incentive or preference to prevent (as if they had that control) hyperinflation is exactly bass ackward. A bank's balance sheet becomes severely damaged in deflation, yet it is made whole through hyperinflation.

 

[sinner]

Swedroe summarising some new findings on volatility/beta/risk in light of skew

http://www.etf.com/sections/etf-industry-perspective/swedroe-when-risk-doesnt-lead-return?nopaging=1

The bottom line is that we now have a significant body of evidence that investor preference for positive skewness results in poor risk-adjusted returns. Those disciplined investors who accept the negative skewness associated with higher-returning assets can build more efficient portfolios.

 

[DeepState]

Swedroe summarising some new findings on volatility/beta/risk in light of skew

http://www.etf.com/sections/etf-industry-perspective/swedroe-when-risk-doesnt-lead-return?nopaging=1

Similar arguments relating to the premium for bearing neg skew are made for carry, momentum, value. An earlier study comparing the difference between upside and downside beta (a measure of skew informed by historical outcomes vs implied vol in this study) showed a premium as well.

To me it suggests that risk premia exposure might be spread away from equity and debt into factor exposures with rewarded risks in light of low return expectations.

 

[fraa]

Similar arguments relating to the premium for bearing neg skew are made for carry, momentum, value. An earlier study comparing the difference between upside and downside beta (a measure of skew informed by historical outcomes vs implied vol in this study) showed a premium as well.

To me it suggests that risk premia exposure might be spread away from equity and debt into factor exposures with rewarded risks in light of low return expectations.

I am a noob, but there are now many factor based etfs springing up like mushrooms. Smart Beta marketing is also popular.

I believe that factor exist as the underlying "limits to arbitrage" logic and observed transient nature makes sense, but would this not be a crowded trade at this time ?

 

[DeepState]

I am a noob, but there are now many factor based etfs springing up like mushrooms. Smart Beta marketing is also popular.

I believe that factor exist as the underlying "limits to arbitrage" logic and observed transient nature makes sense, but would this not be a crowded trade at this time ?

The rise of ETFs has been huge. The factor betas have commonality despite differing definitions. I think it is reasonable to imagine that the trades are crowded as flows to and from ETFs by institutions can create/destroy units. I suppose the risk of such an event depends on the extent to which the capital in the factor ETFs is regarded as permanent as opposed to a flow of capital.

As these simple factor betas grow in AUM, new opportunities are created...

 

[DeepState]

The market is increasingly pricing a significant credit event, possibly via disorderly deleveraging (default or retrenchment).

Key question: Can China's banks withstand the impact of a Yuan devaluation of about 10% (via various channels).

 

[sinner]

IMHO most trades are not as crowded as most people assume.

For every "investment philosophy" $ there is almost always someone else who thinks they can outperform by doing the opposite.

At all timescales.

I prefer the perspective provided by this blogpost, nothing new here as you can see if you'll read it. After reading, for those familiar with many different investment philosophies, styles and strategies, you will see they all approx fit into one of those categories (after you follow all assumptions to their logical conclusions).

https://cssanalytics.wordpress.com/...et-allocation-lessons-from-perold-and-sharpe/

 

[sinner]

The market is increasingly pricing a significant credit event, possibly via disorderly deleveraging (default or retrenchment).

Key question: Can China's banks withstand the impact of a Yuan devaluation of about 10% (via various channels).

Not an expert on the topic so would need the following question answered: are the Chinese banks exposed to currency risk (e.g. short yuan for long dollars)? As per the FOFOA quote I pasted above:

Through the magic of commercial bank double-entry bookkeeping, the banks' balance sheets are actually not exposed to decreases in the purchasing power, or present value of purely symbolic, completely worthless token yuan. They are, however, exposed to decreases in the value of their assets and to the risk of default that flows from deflation. Deposits are nominal liabilities that remain when assets deflate.

Sans currency risk, devaluation should be balance sheet positive...

 

[DeepState]

Not an expert on the topic so would need the following question answered: are the Chinese banks exposed to currency risk (e.g. short yuan for long dollars)? As per the FOFOA quote I pasted above:



Sans currency risk, devaluation should be balance sheet positive...

The banks hedge their FX exposure. Their clients often do not. The banks will see this on their balance sheet as default. A devaluation will see rapid capital outflow initially which will require a monetary response to prevent outright asset and consumer deflation which will trigger a second round. Whether a monetary response to this will be successful is unknown. What I do know is that the CCP and Co could not control the stock market and have not been able to stop their capital account leaking by deca-billions each month. Much research suggests that credit events are preceded by rapid credit growth and asset price inflation. All of the pieces exist for the market to rightfully be concerned. If China falls, EM is next, and Europe comes after that.

 

[fraa]

Thanks Sinner ! Great paper (I just read the original). Unlike other papers that are often variations on a theme, this one lays out an elegant truth. Love it.

Had a thought reading the paper - the Vanguard/Boglehead market cap passive investing framework rests upon 2 pillars

1. For non market average return, someone must lose for someone to win. Casual investors should take market avg returns as wins are not certain for most (power law ?) so it is not worth it.
2. Market cap weighting means EVERYONE can hold the passive investing portfolio, so it is unique in that the trade cannot be crowded.

Putting aside that many passive investors do not hold the proper global market portfolio (exhibiting both home bias in the equity index etc), the balancing process used is constant mix with a concave payoff. As laid out in the paper, not everyone can adopt a concave payoff (only buy and hold...) and as more adopt a concave payoff, it becomes more costly to implement...

Have been reading up on Boglehead style passive investing to see where the "Gotcha" is as I am looking to invest a decent sum - for the framework to hold, all participants must straight Buy and Hold the Global Market portfolio. But few, if any passive investors actually do this - many do not invest in international equities (home bias) and all deviate from the FI/Equity split of the Global Market Portfolio as they perform asset allocation based on their risk appetite (ie age), which then requires an annual a constant split rebalance process that has a non-market neutral concave payoff...

Does this means pillar 2 above does not actually hold, the market can become unbalanced and passive investing can become "crowded" ?

Given the ever increasing inflows into passive investing and the death of active management, will this mean a potentially major market distortion will be introduced over time ? What form will the distortion take ?

Or am I missing something ?

Also Sinner, any other recommendations for other papers illustrating similar "truths" in the market ? Would love to get ahold of your reading list.

ps sorry for hijacking your thread DS, started this post with only vague thoughts and it kinda grew from there.

IMHO most trades are not as crowded as most people assume.

For every "investment philosophy" $ there is almost always someone else who thinks they can outperform by doing the opposite.

At all timescales.

I prefer the perspective provided by this blogpost, nothing new here as you can see if you'll read it. After reading, for those familiar with many different investment philosophies, styles and strategies, you will see they all approx fit into one of those categories (after you follow all assumptions to their logical conclusions).

https://cssanalytics.wordpress.com/...et-allocation-lessons-from-perold-and-sharpe/