Mailbag: Deadly. Holy. Rough. Immediate.

0

A challenging question from reader David S. He quotes from and responds to an excerpt from Deadly. Holy. Rough. Immediate.

“Over very long periods, you will generally be paid based on the risks an average investor (including all of his liquidity sensitivities, his investment horizons, etc.) would be taking if he made that investment.” (from Deadly. Holy. Rough. Immediate.)

Isn’t this idea built on risk spreads, building up from the risk-free rate?  But in a world where central banks set risk-free rates for other reasons, is the concept of a risk-free rate even coherent?  In other words, does anyone really think Italian government debt is safer than U.S. government debt right now?

Again, it’s a useless theoretical question.  I think risk spreads work; will continue to work; and, even if I felt otherwise, I wouldn’t be foolish enough to try to predict the timing.  But how solid is the theoretical foundation on this one?

Over a sufficiently long horizon, I’d say it’s about a 6 out of 10 (which is about as good as it gets in this game).

There are probably more finance papers on the topic of the relationship between risk and return, or premia for the fancy among us, than any other. Many of them are purely empirical (e.g. what are the long-term Sharpe ratios of different asset classes over various horizons?). Many are purely theoretical (e.g. how should markets with mostly rational actors function to price risk?). Some are a bit of both (e.g. how much of variability in stock prices is driven by changes in expectations vs. changes in discount rates?). Even as a Hayekian who thinks that prices separate us from Communists and the animals, I’m kind of with you. To practitioners, the explanations and frameworks offered by these papers are often unsatisfying.

Over many very long horizons, the data will show you that the Sharpe ratios of major asset classes are similar. In other words, the relationship between the variability in price and long-term returns above a risk-free rate appears to be pretty consistent across assets. You’ll hear this factoid a lot in defense of the idea that long-term risk-adjusted returns of assets should be comparable if investors are at all rational. But this is one of those cases where I think we’ve got to be a little bit skeptical of a surprisingly geometric cow. One exaggerated example?

Commodities.

Their long-run Sharpe ratio is not far off from those of financial assets (this obviously depends on horizon – you’ve, uh, gotta go back for this one). But any sort of attempt to build a theory about why our return expectations for commodities should have anything to do with how volatile their prices are ends up looking like a dog chasing its tail. The practitioner sees this, because he sees how much of a commodity’s price changes are directly driven by non-economic actors, substitutability, seasonality, weather, extraction costs, storage costs, hedgers, etc. Plus, y’know, supply and demand.

This is part of the reason why many practitioners do NOT treat commodities – and this includes things like Bitcoin and other cryptocurrencies, by the way – as investable asset classes. We may have some expectation of their rise, but it is hard to determine in any meaningful theoretical way why we should expect to be paid with returns in any proportion to the risks we are taking on by owning them. Incidentally, I don’t think you need to believe there is a commodity risk premium to justify holding commodities in a portfolio. I would say the same thing about cryptocurrencies if I believed there was a state of the world in which they wouldn’t be treated as a highly correlated speculative asset in any kind of sell-off event for risky assets.

This isn’t just a commodity phenomenon. To David’s point, I think it is obvious that there is a portion of the risk we take in owning financial assets – stocks, bonds and other claims on cash flows – that we probably ought not to expect to be paid for either, or at least for which the smooth, ‘rational actor’ transmission mechanism between risk and the price demanded for it is perhaps not-so-smooth. Low-vol phenomenon, anyone? A half dozen other premia? But prices for financial assets are also hilariously overdetermined. That means that if we line up all the things that influence those prices, we will explain them many times over. It’s a topic that occupies the entire lives and careers of people smarter and more dedicated to the subject than I am, so I hesitate to give it the short shrift I am here. But in the interest of responding somewhat substantively, let me tell you in short what I think:

  • I think that the risk differences caused by placement in capital structure and leverage should have a pretty strong long-term relationship with return, because they describe an actual cash flow waterfall connected to economic reality. This is why I feel confident that I’m going to be paid some spread – even if it isn’t completely proportionate – for risks I take by owning risky financial assets.
  • I think that the risk differences caused by country and currency have a weaker relationship with return. You’ll be able to find examples where this isn’t true, but in general, capital markets still exhibit very local characteristics. Assuming that the differences in realized risk between markets in two countries will give us reliable information about how participants in those markets are pricing their relative risk may be pretty unrealistic.

In practice, I think that the first bullet alone is powerful enough to make it a foundational principle of portfolio construction. Perhaps the most important. I also think it is strong enough that it matters even if you think that a significant portion of price variability and movement is driven by abstraction, game-playing and narrative.

P.S. Folks, if you’re thinking about writing me that volatility isn’t risk, please don’t.

0

Leave a Reply

Please Login to comment
  Subscribe  
Notify of

Disclosures

This commentary is being provided to you as general information only and should not be taken as investment advice. The opinions expressed in these materials represent the personal views of the author(s). It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. Any action that you take as a result of information contained in this document is ultimately your responsibility. Epsilon Theory will not accept liability for any loss or damage, including without limitation to any loss of profit, which may arise directly or indirectly from use of or reliance on such information. Consult your investment advisor before making any investment decisions. It must be noted, that no one can accurately predict the future of the market with certainty or guarantee future investment performance. Past performance is not a guarantee of future results.

Statements in this communication are forward-looking statements.

The forward-looking statements and other views expressed herein are as of the date of this publication. Actual future results or occurrences may differ significantly from those anticipated in any forward-looking statements, and there is no guarantee that any predictions will come to pass. The views expressed herein are subject to change at any time, due to numerous market and other factors. Epsilon Theory disclaims any obligation to update publicly or revise any forward-looking statements or views expressed herein.

This information is neither an offer to sell nor a solicitation of any offer to buy any securities.

This commentary has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. Epsilon Theory recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.