Fake Alpha
Raghuran Rajan gets it absolutely right:
For example, an investment manager who bought AAA-rated tranches of collateralised debt obligations (CDO) in the past generated a return of 50 to 60 basis points higher than a similar AAA-rated corporate bond. That “excess” return was in fact compensation for the “tail” risk that the CDO would default, a risk that was no doubt perceived as small when the housing market was rollicking along, but which was not zero. If all the manager had disclosed was the high rating of his investment portfolio he would have looked like a genius, making money without additional risk, even more so if he multiplied his “excess” return by leverage. Similarly, the management of Northern Rock followed the old strategy of taking on tail risk, borrowing short and lending long and praying that the unlikely event of a liquidity shortage never materialised. All these strategies essentially earn the manager a premium in normal times for taking on beta risk that materialises only infrequently. These premiums are not alpha, since they are wiped out when the risk materialises.
Related:
The flawed logic behind the bonus bonanza
“Bankers’ pay is deeply flawed”
January 9th, 2008 at 8:19 am
[...] Wednesday links: fake alpha 09Jan08 Was there really any alpha to be found in CDO structures? (Alea) [...]
January 9th, 2008 at 9:24 pm
These premiums are not alpha…
The world would be better off if we wiped “alpha” out of all our equations and replaced it with another greek letter, maybe “Capital sigma,” to indicate that we don’t really know what the average return is; it’s a risk factor with uncertainty and a non-zero expected return.
Perfect for the example above. Great for all these “enhanced” type strategies which get “alpha” by betting on book/price or some other factor that works great until it doesn’t.
There really isn’t an alpha (a constant-rate return without variability), except those negative alphas called, “fees.”
January 9th, 2008 at 11:19 pm
Who ever said alpha had no variablility? Only the very naive believe such things exist!
Any decent discussion of active managment (eg. Grinold & Kahn) will highlight the concept of active risk (the expected standard deviation of alpha). Active managers are usually compared using information ratios (ratio of alpha to active risk). Like a Sharpe ratio and an IR of one is considered to be very good.
The issue above is simultaneously overestimating return and underestimating risk by ignoring low probabilty but large loss events(asymetric returns) not thinking there is no risk at all.
January 10th, 2008 at 11:32 am
I am sympathetic to Walt’s argument, though one shouldn’t be too dogmatic for a few have somewhat miraculously manufactured “it”, through thick & thin, if not from a single source with no variability, then through a portfolio of [continually evolving] diversified sources, with sufficient attention to risk factor covariance - realized & potential - that the resulting return stream has been reasonably close to the ideal.
As for the calling of excess returns derived from implicit risks of CDOs Alpha, most non-interested informed observers could have (and probably did) performed an entertaining beer-enabled thought experiment of imagining what might deterministically happen to such structures when the credit cycle sours, asset collateral prices fall, bankruptcies rise, and credit spreads widen. Such losses from highly negative-gamma-to-credit structures would in the extreme be terminal and absolute. In defense of some quantitatively mined, equity-based let’s call them “pseudo-alpha” strategies, many thoughtfully constructed convergent strategies can tolerate temporarily wider spreads or more divergence without being terminally extinguished, and so, over-time, sufficiently capture excess returns necessary to provide adequate rewards to capital for the undertaking. And though Walt is correct about the “variability”, I would suggest that variability in and of itself is not sufficient alone to indict the pursuit given adequate return.
March 9th, 2008 at 1:51 pm
[...] Fake Alpha The illusion of high profitability creates additional problems. To the extent that salaries and bonuses are based on reported short-term profits without adjustment for reserves against shocks, the line officers who are in the best position to assess such dangers will be rewarded for disregarding them. In addition, competition may interact with disaster myopia in two related ways to increase vulnerability. First, competitive markets make it impossible for banks that are not disaster myopic to price transactions as if there were a finite probability of a major shock when banks and other competitors who are disaster myopic price them as if that probability were zero. Second, if banks are apparently earning returns above the competitive level (disregarding the need for reserves against future shocks), equally myopic banks will be encouraged to enter the market, thus eroding those returns. In response, banks can protect target rates of return on equity for a time by increasing their leverage and rationalizing such actions in terms of the need to maintain target returns in the face of shrinking margins, and in terms of similar actions by other banks. Thus competition, interacting with disaster myopia, may accelerate the process through which banks become increasingly vulnerable to a major shock like a collapse in real estate prices. Once a shock occurs, disaster myopia turns into disaster magnification. The availability heuristic may exacerbate financial conditions because, just after a shock has occurred, it is all too easy to imagine another sharp decline in real estate prices and the subjective shock probability will rise well above the true shock probability. As Guttentag and Herring (1984) show, this will result in sharply increased tiering of interest rates in financial markets as lenders try to reduce exposures and increase risk premiums in response to sharply higher shock probabilities. The extent of credit rationing is likely to expand for borrowers who cannot offer a credible contractual rate that will compensate for the increase in the perceived risk of default. The abrupt drop in the flow of credit to the real estate market will put further downward pressure on real estate prices. This is also likely to diminish lending to other sectors of the economy as banks try to rebuild their reserves and capital to cope with the increased risk of default. To the extent that supervisors and regulators are susceptible to disaster myopia, they are also likely to suffer from disaster magnification. In response to the greatly increased subjective probability of a disaster they may seek to protect the banking system by insisting on higher capital ratios and more aggressive provisioning against potential losses. [...]