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.
Some super-safe investment, like AAA tranches of CDO securities in 2008, turned out not to be so safe.
can you believe it - Falkenstein's PhD dissertation
what could I calculate in a minute to create a reasonable portfolio of equity securities? RP would do alright, in my view.
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?
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?
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.
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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.
What happens when:
If that stage show happens, it's likely a sell this time around.
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
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.
This is not a prediction of the end of the financial system etc.
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.
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.
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.
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 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).
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.
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...
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/
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