What does your portfolio say about you?

2/10/2013Apurv Jain

Capital Markets GroupMSFT

Definitions

• Systematic Risk– Something that affects everyone- the whole economy

• Can explain this in a factor model framework like CAPM as the market portfolio

• Idiosyncratic Risk– Something particular to an individual (company)

• Investing– Expecting rewards for bearing “systematic risk”

• Speculation– Expecting to win by bearing “non systematic risk”

• Beta– I AM WITH THE CROWD– Investing in one asset class or type of risk every time

• Alpha– I AM SPECIAL and BETTER THAN YOU– Beating the market consistently but not taking any one direction in one asset consistently

• Rest as we go along

What do we know?

• Taking risk has generally been rewarded– Triumph of the optimists– Linear relationship according to most asset pricing models

• Usually No free lunch – No Arbitrage can be used to get to Black Scholes

• Not easy to beat the market– i.e. predict short term returns and beat transaction costs– Market efficiency studies (Fama 1970)

• Diversification generally helps

What we sort of know

• Central banks matter

• Asset volatility is higher than macroeconomic volatility

• Different periods in Business cycles produce different returns

• Value stocks and small stocks outperform the market

• Blindly trusting equations can blow you up– “good traders” can help avoid that…

• Human being have many cognitive biases…– models can help you avoid those….

What I believe• Collecting various kind of risk premium is smart• You can beat the market but it is hard

– Always ask what the “edge” is?• Structural Factors can be big edges

– People overpay for leverage– Pension funds invest in suboptimal portfolios due to

regulation• Growth, inflation and credit creation can help

think about what asset classes to invest inGrowth high Growth Low

Inflation High CommoditiesReal Estate

IL Bonds

Inflation Low StocksCredit

Nominal Bonds

What is the debate about?

• Physics => Laws

• Finance => Generalizations!

• Finance is a noisy social science but it matters

• There is no perfect agreement on anything in finance– Unlike Physics humans don’t follow laws when it comes to consumption

vs.• Statistical significance vs. Economic Significance

– 16 years of data to know if stocks STATISTICALLY (at 95% confidence level) outperform bonds

– Economic significance of a winning portfolio is big! A 4.5% higher return over 16 years means doubling your money!

Investing choices we will talk about

• Stock Mutual Funds– With active management– Passive management

• Bond Managers– Govt. Bonds– Corporate Bonds

• CTA– Trend Followers

• Hedge Funds– Absolute return– Exotic beta types– Global Macro

• Private Equity

• Venture Capital

• Real Estate

Summarizing Investors

• Characteristics– Capital

– Risk Tolerance

– Investing Horizon

– Sophistication

• Market Beliefs

Stock Mutual Fund

• If you invest in actively managed stock mutual fund- GENERALLY – Reasonable risk tolerance– Longer investing horizon– Are Naïve

• Have NOT taken a finance course since you are OVERPAYING • Believe your manager can beat the market => do NOT know how to

run regressions!*– Optimistic

• Low fee Index Funds– sophisticated*Some managers do beat the market consistently but it more style predicated so if you don’t know much don’t give them your money! *It may also be harder to get into their funds at lower cost if you are not an institutional investor

Bond Managers

• Characteristics– Older– Lower risk tolerance– Known liabilities

• Market Beliefs– Pessimistic on growth (nominal and inflation linked

bonds)– Optimistic on inflation (For Inflation linked bonds)– Optimistic on low defaults if buying corporate bonds

CTA

• Characteristics– Richer than simply mutual fund investor– Short/long time horizon– Moderate risk tolerance (around 10% vol but may have jump losses)

• Market Beliefs– Believe “Trend Following” works– Believe in “Technical Analysis”– Price and volume contain information about the future prices

• My Comments– Momentum trading does seem to help outperform with stocks but have to

be careful about small , illiquid stocks– Momentum and trends also work on FX, commodities and most markets. – Could it be something to do with human nature? My current research topic

Hedge Funds

• Characteristics– Rich– Risk Taking– Sophisticated investor or Naïve rich fool?

• If you are paying 2 and 20 for beta you are naïve• If you got into a top hedge fund that has an edge,

then sophisticated– Have a good network

• Market Beliefs– Believe that markets have inefficiencies – Micro inefficiencies @ Absolute return funds– Macro inefficiencies @ Global Macro Funds– Mispriced risk premia @ exotic beta funds

Absolute Return Hedge Funds

• Equity Market Neutral, Fixed Income Arb

• Really believe in your manager– Likely overpaying for illiquidity beta (more likely) or

unknown beta– Really have a manager that has a better mousetrap (less

likely but possible)

• Believe market is inefficient and can be consistently exploited

• Crowded positions is a big risk

Exotic Beta generating Hedge Funds

• Believe bearing complex risks have more reward– Merger Arbitrage, Convertible Arbitrage, Emerging

Markets– Be careful that returns are not only coming from lack of

mark to market accounting– Exposure to illiquidity

• Naïve if paying 2 and 20– Can do exotic beta cheaper– Hopefully not paying for fund of funds type of structure– An organization I know invests in 100 hedge funds! That

basically delivers the market portfolio

Private Equity

• Characteristics– Rich– Risk taking– Long horizon (money locked in for years)

• Market Beliefs – Believe that public markets force management to make

suboptimal decisions (esp. on restructuring)– => better alignment of interest between investor board

and management by taking the company private– Adding debt enforces manager discipline– Useful to invest in something illiquid due to accounting

treatment

Venture Capital

• Characteristics– Rich– Risk taking– Long horizon (money locked in for years)– “Adventurous”/”Futurist”/ Seek to invest in innovation

• Market Beliefs– Complex technologies can be better valued by experts– The best return is taking on the option like risk of new

technologies until the public market values them– Beyond that they become growth companies!

Real Estate

• Characteristics– Many types of real estate investing

• Ordinary people buy it for consumption (or a substitution for rent) or easiest way to get leverage on something illiquid

• Big investors buy it for inflation hedge or to own their land– Long time horizon– Decent risk tolerance if investing

• Beliefs about the market– Inflation likely to happen– Easy to borrow money =>Levering up is a good idea– Have information about land use change or expect

population to grow

Are these beliefs true? A look at performance

Hedge Funds have done well since 1990 but post 2004 has been more challenging

Hedge Fund Performance 2004 to today (CS TASS Database)

Dedicated Short Bias

Global Macro

Managed Futures

Multi Strategy

Convertible Arbitrage

Fixed Income Arbitrage

Equity Market Neutral

Event Driven

CS All Hedge Index

Emerging Markets

Long/Short Equity

S&P 500-8.78%

1.32%

3.94%2.86%

1.96%

-2.44%

-14.95%

5.16%

3.05%4.85%4.47%

7.85%

Av. Return

Dedicated Short Bias

Global Macro

Managed Futures

Multi Strategy

Convertible Arbitrage

Fixed Income Arbitrage

Equity Market Neutral

Event Driven

CS All Hedge Index

Emerging Markets

Long/Short Equity

S&P 500

-0.57

0.15

0.39 0.390.17

-0.26

-1.57

0.67

0.440.35

0.51 0.51

-60%

29%48% 56% 57% 58% 59%

72% 77% 82% 84%100%

Sharpe vs. Correlation

Private Equity and VC vs. index correlations have been rising

Like in most specialized things top guys continue to do well

Conclusion

• Know yourself– What are my characteristics

• Try to know the market – Do your research on the market and see what you

believe• Questions

– What is my edge?– What is the person to whom I am handing over the

money’s edge?• This is a really cool problem so hopefully some of

you wil do research on it!

Common Beliefs about Asset Classes