Friday, November 28, 2008

Where does alpha come from?

Alpha comes from maximising winners and minimising losers, according to research carried out by Inalytics (reported in

“The typical manager, however, compensates for a mediocre hit rate by generating good gains from the winners,” according to the report. The win/loss ratio — defined as the alpha generated from good decisions compared to the alpha lost from wrong decisions — averages 102%. This translates to an average alpha of two percentage points.

Active equity managers also obtain more alpha in their overweight decisions than their underweight choices. Managers made the correct decisions to overweight a stock relative to its appropriate index about 48.5% of the time. But the win/loss ratio was 113.9%, meaning alpha averaged 13.9 percentage points.

Thursday, November 20, 2008

Importance of feedback effects

Raghuram Rajan looks at the crisis. One interesting focus is the effect of feedback loops. This is a common theme. Buying leads to capital appreciation and additional buying. This just drives the price further away from fundamental value and increases the risk.

Wednesday, November 19, 2008

Tuesday, November 18, 2008

Roman Credit Crunch

From Tacitus, a credit crunch in Rome (ht tired fools).

Meanwhile a powerful host of accusers fell with sudden fury on the class which systematically increased its wealth by usury in defiance of a law passed by Caesar the Dictator defining the terms of lending money and of holding estates in Italy, a law long obsolete because the public good is sacrificed to private interest. The curse of usury was indeed of old standing in Rome and a most frequent cause of sedition and discord, and it was therefore repressed even in the early days of a less corrupt morality. First, the Twelve Tables prohibited any one from exacting more than 10 per cent., when, previously, the rate had depended on the caprice of the wealthy. Subsequently, by a bill brought in by the tribunes, interest was reduced to half that amount, and finally compound interest was wholly forbidden. A check too was put by several enactments of the people on evasions which, though continually put down, still, through strange artifices, reappeared. On this occasion, however, Gracchus, the praetor, to whose jurisdiction the inquiry had fallen, felt himself compelled by the number of persons endangered to refer the matter to the Senate. In their dismay the senators, not one of whom was free from similar guilt, threw themselves on the emperor's indulgence. He yielded, and a year and six months were granted, within which every one was to settle his private accounts conformably to the requirements of the law.

Hence followed a scarcity of money, a great shock being given to all credit, the current coin too, in consequence of the conviction of so many persons and the sale of their property, being locked up in the imperial treasury or the public exchequer. To meet this, the Senate had directed that every creditor should have two-thirds his capital secured on estates in Italy. Creditors however were suing for payment in full, and it was not respectable for persons when sued to break faith. So, at first, there were clamorous meetings and importunate entreaties; then noisy applications to the praetor's court. And the very device intended as a remedy, the sale and purchase of estates, proved the contrary, as the usurers had hoarded up all their money for buying land. The facilities for selling were followed by a fall of prices, and the deeper a man was in debt, the more reluctantly did he part with his property, and many were utterly ruined. The destruction of private wealth precipitated the fall of rank and reputation, till at last the emperor interposed his aid by distributing throughout the banks a hundred million sesterces, and allowing freedom to borrow without interest for three years, provided the borrower gave security to the State in land to double the amount. Credit was thus restored, and gradually private lenders were found. The purchase too of estates was not carried out according to the letter of the Senate's decree, rigour at the outset, as usual with such matters, becoming negligence in the end.

Monday, November 17, 2008

Global supply chain and credit crisis

The FT looks at the effect of the credit crisis on the global supply chain:

The message from Paul Lester, chief executive, was stark: “If you get into financial difficulties, don’t delay but come and talk to us. You are probably better talking to us than banks, because banks aren’t really doing their jobs right now and we can help.”

Possibilities for help include paying suppliers in cash earlier, giving them longer orders or even lending them workers, says Mr Lester. At Safran, Mr Dessemond says his company could put capital into its suppliers, help them obtain aid from government agencies or change payment terms – but all only in “exceptional cases”.

The usual issues banking problems of checking amidst informational asymmetries, monitoring and compliance will arise. Partnerships are possible. At some point it becomes better to take control of the whole company.

Thursday, November 13, 2008

Skew and tails everywhere

More insight into the way that there was skew and long-tails throughout the industry.
Yale and Princeton universities have 70% of assets in alternatives, while Harvard University's allocation is 57%. These holdings have helped them generate strong returns over the past decade, but have been unable to offer diversification and liquidity.

Harvard, Yale and Princeton have declined to disclose their recent returns, but it is estimated that that each may be down 25% or more since June 30.

More scope for unwind and fire sale of assets.

Asian toxic assets

The FT has coverage of the risky assets that now pollute Asian financial institutions' balance sheets.

While US bankers were securitising everything in sight, their Asian peers were busy stitching together financing for unlisted mid-cap companies. These deals ticked all the right boxes: fat income streams for bankers, cash for riskier borrowers who lacked track records, and high-yielding assets for hedge funds to snaffle up. As importantly for Asia’s privacy-fixated tycoons, the deals flew below the public radar. Bankers’ guestimates of the dealflow are around the $10-20bn mark.

Yet, as with subprime, these structured loans no longer look so smart. Many of the biggest users of these pre-IPO convertibles were in sectors that are now reeling, particularly Asian real estate. Essentially debt with equity upside, they were predicated on initial public offerings at bloated 2007-style multiples, upwards of 30 times projected earnings. Many deals were written at the top of the market when participation was more important than analysis. In the worst cases, term sheets barely covered an A4 sheet of paper and due diligence was often cursory. Now that the IPO exit is effectively shuttered, hedge funds and other investors find themselves loaded up with illiquid paper they have no way of marking to market. Sound familiar?

When we add this to the widespread appreciation of risky assets it is becoming more clear that this less a problem of regulation (though regulations can limit the greatest excess) or bad people, but more an issue of too much money. It had to go somewhere.

Tuesday, November 11, 2008


Eliezer Yudkowsky looks at an experiment with known probability that produces behavioural bias. This would be a very good one to use in the class.

"Many psychological experiments were conducted in the late 1950s and early 1960s in which subjects were asked to predict the outcome of an event that had a random component but yet had base-rate predictability - for example, subjects were asked to predict whether the next card the experiment turned over would be red or blue in a context in which 70% of the cards were blue, but in which the sequence of red and blue cards was totally random.

In such a situation, the strategy that will yield the highest proportion of success is to predict the more common event. For example, if 70% of the cards are blue, then predicting blue on every trial yields a 70% success rate.

What subjects tended to do instead, however, was match probabilities - that is, predict the more probable event with the relative frequency with which it occurred. For example, subjects tended to predict 70% of the time that the blue card would occur and 30% of the time that the red card would occur. Such a strategy yields a 58% success rate, because the subjects are correct 70% of the time when the blue card occurs (which happens with probability .70) and 30% of the time when the red card occurs (which happens with probability .30); .70 * .70 + .30 * .30 = .58".

Can this make people believe that they are over-confident?

Risky assets

Brad Setser looks at the way that investment banks built up the level of risky securitised issues on their balance sheet.

Her article — which included the Winters quote — didn’t just look at Merrill though. She noted that Wall Street was a big buyer of mortgages for its “private label” mortgage backed securities at the peak of the housing boom. Morgenson reports that the Street issued $178 billion of mortgage and asset backed CDOS in 2005 – and an incredible $316 billion in 2006. 2006 was when the quest for yield was at its most intense. Short-term interest rates had been raised. That should have squeezed profits. The fact that it didn’t should have been a warning sign.

I would like to relate this to Setser's other interest - the purhcase of safe treasury bonds and agencies from the US and the shape of the US yield curve.