Category: Investments

Risk and return. The drumbeat that return is received in exchange for taking on risk as measured by volatility is relentlessly driven into the minds of all investors, but what if this trade-off is not as strong as the rhetoric? New research focuses on skew as one of the key risks. In particular the downside risk of negative skew may be more important at explaining excess returns than volatility which can lead to either upside or downside.

“Take nothing on its looks; take everything on evidence. There’s no better rule.” — Mr. Jaggers, Pip’s guardian in Great Expectations by Charles Dickens.

If we had Mr. Jaggers as our guardian and mentor, we would likely be better analysts. A recurring theme this month has been about finding the truth through a focus on data, not commentary. Look to the data and not what is being said. If there is no supporting evidence, discount. If no supporting evidence is provided, then find your own. Markets may be driven by sentiment or perception but ultimately it will discount and respond the evidence.

The paradox of skill is an important concept to understand for any investor or trader. Managers will often talk about wanting to prove their skills in a competitive environment against the best in the world. Forget that nonsense. You want to be the best in an uncompetitive or less competitive environment. You want to have a strategy that others do not follow. Being in a competitive space may seem like a good thing, but it will be harder to beat others. If there is a fixed amount of alpha, everyone will be fighting for that same alpha and it will be harder to win your share when the market is more competitive.

We have described August as the dog days of summer given the limited movement in major asset classes; nevertheless, we were seeing more dispersion within equity and bond sectors, styles, and country indices. Moving averages are flattening and there are less clear signals within our sector groupings. It is unclear how long range-bound behavior will last given that the Fall season for financial markets, when trading activity picks-up, starts next week.

“What is your Sharpe?” This is one of the first questions that is always asked of managers. The mangers will firmly reply, “My Sharpe ratio is X.” The conversation then moves onto the next question as if this one number serves to address the performance issue, yet the Sharpe ratio is dynamic. In a drawdown, no one wants to even see that number. When things are going well, the Sharpe ratio is king. Investors have to accept that this is a variable number because the underlying assets bought by funds have variable Sharpe ratios.

Liquidity is never present when you need it. This truism is especially the case when there is a financial crisis. A crisis become a liquidity event if sellers cannot find buyers at a fair price or at extreme any price. If the security is more specialized or complex, it will be even harder for the seller to find buyers. There will have to be a greater price decline from fair value before a buyer is found.