Wednesday, July 26, 2017

The incredible shrinking alpha - falling skill or alternative definitions?


The beta battle of what portion of returns can be explained by systematic factors continues across the asset management world. However, it is not so much a battle of performance breakdown between beta and alpha skill but of definition. What used to be called alpha in a simple one-factor world can now be partially described as a beta. The alpha manager of yesterday is partially the alternative or smart beta manager of today not by design but from construction. The incredible shrinking alpha is associated with the incredible growing betas. 


We focus on the changing definition of alpha by looking at a simple graphical depiction of how returns have been decomposed into different betas (factors or risk premiums). In an old hedge fund world, the total returns were viewed as the skill of the manager. From this simplistic view, there was the advancement into the market beta view where returns could be decomposed into market beta and manager skill or alpha. In this advanced world, alpha has fallen and there is a discussion on whether investors should pay for beta. 

We are now in the alternative risk premium world which states that hedge fund returns can be further decomposed into a market and assorted risk premiums like value and size to name two of the most common. The alternative betas can be further decomposed into carry, momentum, or defined factors. As more "betas" are used to describe hedge fund returns, the alpha based skill is further shrunk. Of course, there may be skill navigating and weighing different risk premiums but that is a different discussion.

The result of more betas is a shrinking alpha that can be attributed to manager skill. It is not that managers have gotten less smart, but investors have gotten smarter at defining what are appropriate betas. The skill of managers could actually be increasing through time after accounting for all the appropriate betas. This issue defining the betas in a fund is actually complex and skill identification has gotten more nuanced.   

Monday, July 24, 2017

A simple taxonomy of diversification - All diversifiers are not alike



When I hear about diversification across funds or strategies, I, like most investors, will immediately focus on the correlation matrix versus other alternatives and asset classes. However, investors should be thinking beyond the simple historical numbers and focus on forward expectations for correlations. There should be views of how diversification may change through time or behave under different scenarios. To form diversification or correlation forecasts, investors should have a classification scheme for diversification. All diversification is not alike and a classification scheme may help with determining how correlation may move. 

For example, if an investor asks for a strategy that has diversification to protect in a crisis, they have embedded a forward view of what they would like to see the correlation to look like under an extreme scenario. There are also placing a weight on the likelihood of a crisis that may drive a correlation disruption.

More generally, the correlation of an asset class or a fund is based on the sensitivities to different factors or risk premiums. A simple taxonomy of diversification could breakdown a market, manager, or strategy into five different types or buckets. The easiest diversification classification is an asset class. However, asset class correlation can change with the business, cycle, investment flows, and in a crisis. The simplest and perhaps best diversification currently is the negative relationship between stocks and bonds; however, there have been long periods when this correlation has actually been positive. Any diversification strategy has to account for the fact that the negative stock bond correlation is not definitive.

A second type of diversification is based on factors.  Factor-based diversification is often confused with alternative risk premiums. Our view is that a factor could see some macro variable or characteristics that been be correlated to an asset class, market or strategy.  Simple examples of a factor-based diversification will be sensitivity to inflation or economic growth.  The alternative risk premium diversification may include sensitivities to value, size, term premium, or credit to name some classics. Some of the have proved to move and out of favor.

A separate category of the asset class/factor/risk premium diversification is the crisis alpha type of strategies which have low or negative correlation during "bad times". These scenario-based diversifiers could be safe assets or a strategy that will take advantage of market turbulence or diversification.

A final type of diversification is from those managers who are alpha producers or who focus on short-term strategies that will not be dependent on the overall longer-term direction of a market or risk factor. I will call this skill-based diversification. It can be hard to find but may prove stable relative to many forms of diversification based on macro factors.


This taxonomy just scratches the surface on an issue that if fundamental to asset allocation but is critical to an attempt to maximize portfolio return to risk. While portfolio diversification has often been called the only free lunch of investments, this freebie can be enhanced through some thought on the form of diversification across scenarios.

Saturday, July 22, 2017

Managed futures in a drawdown - How bad is it? - Take a look


The managed futures hedge fund strategy, as measured by a well-watched peer group index, is in a major drawdown. In spite of this, money is still flowed as investors have taken a forward looking view of what this strategy will do if there is a sell-off in major asset classes like equities. 

Of course, indices do not represent the behavior of individual managers within this space. There are winners and strategies that have made money over the last two years. It is just that the search may be a little more difficult because many big names which focus on longer-term trends in financial markets have had fewer profitable opportunities. In general, better diversified managers across style, timing and markets have done better.

Our first chart shows the value of the SocGen CTA index since inception with a trend and quadratic line fitted through the index values. There was a clear fall below trend in 2016 which has accelerated.

The actual drawdown is at an index maximum beyond 12%. There have been 10% plus drawdowns in the past; however, those have been in periods of higher market volatility. A quick analysis shows that the amount of time that is spent at high water marks is usually low, about 20% of the months, and the amount of time beyond a 7% percent drawdown is also low at about 20%. Getting to this drawdown was not unusually fast albeit the last year has been shown a strong trend.
We also looked at the index using a rolling 24-month linear trend model which provides some deeper visual insight on the current down trend. It is steep with the inflection point in early 2016.  The one step ahead forecast from the linear trend can be used to see how managed futures have deviated from recent trend. The data show that current poor performance has been much stronger than the down trend and unusual relative to past linear forecasts.

For those that have invested in managed futures, the last eighteen have been difficult but from a forward looking perspective the likelihood for either a disruption in equity or bond markets has increased and the likelihood of a further drawdown based on current strategy volatility is lower. Drawdowns are path dependent. Hence, the past history is relevant yet expectations of potential market turbulence may be more important for current allocation decisions.


Friday, July 21, 2017

Cost of liquidity - The hidden management fee that needs to be calculated


Investors are looking closely at the fees being charged, but the hidden fee of liquidity may be the most significant cost that is often not talked about. Large firms that are charging less may have higher costs associated with liquidity than small firms. As the size of the firm grows,  the cost of entering and exiting may be higher. Additionally, some markets that may offer opportunities are avoided because the cost of trading when liquidity is lower is higher.

There are economies of scale for managing a hedge fund business as a firm grows, but there are potential diseconomies of scale associated with the investment management of the business. You may get firms to be much more competitive on price as the assets under management grow or as it prices a large new inflow, but there may also be higher investment costs with running the money. One way to combat this higher liquidity cost is to increase expenditure and resources on trading and execution algorithms.

As firms get larger or price based solely as a management fee there may be the potential for misalignment of incentives and hidden performance costs. Larger firms that have covered fixed costs could easily focus more on incentive fees but it seems merely likely they will cut incentives and actually skew toward locking in management fees. 

There is a trade-off between the benefits from scale through risk management, research, execution, and business cost savings against the costs of liquidity management. There will be a point where the added net return from scale is outweighed by the performance drag from liquidity shortages.

Nevertheless, the cost of liquidity is extremely hard to measure because when you need it, it will not be available. The inflection point between economies and diseconomies of scale is hard to determine. So a natural question is, "What is the capacity of any given firm?" and "What is the capacity for a given strategy or across all firms pursuing the same strategy?" 

It is surprising that more firms have not closed to new investments as they have grown. It is likely most firms are optimistic and gauge capacity on the high side. Additionally, back of the envelope calculations on trading across firms suggest that many trades can easily be considered crowded. Discounting the uncertainty of liquidity is more important than calculating the discount or savings from lower management fees. 

Wednesday, July 19, 2017

It's a electronic futures world - Now what do we do? The changing role of brokerage


Automated execution is taking over futures markets. Actually, the battle is over. Voice (non-electronic) and manual execution are reserved for illiquid products, old school firms, smaller traders, those who may be undertaking spreads, complex legged or option strategies, roll strategies, and some block trade. However, the use of electronic trading can vary by market and sector. Technically, we are referring to manual (MAN) versus automated (ATS) trade execution where automated is generated and/or routed without human intervention. Non-electronic would be a separate category. By far, automated to automated trades dominate most markets even in many commodities.  The high frequency automated traders are the new market scalpers. Financials have a higher percentage of automated trading over commodity markets.

From the latest CFTC research, (see Automated Trading in Futures Markets by Haynes and Roberts), we have a graphical analysis of the ascent of automated trading across many markets. Some markets have seen slower growth but the direction is all the same.

What does this mean for the brokerage world? The overall theme is that relationship brokerage has come to an end. We define the old world of relationship brokerage as an environment where brokers provided access to execution services, generated trade ideas and execution strategies for working an order, and market color from what they were seeing in the market. The new world provides easy market execution services and connectivity at low prices, but there is limited interaction between users and brokers concerning trade ideas and market color. The fee and service of a broker relationship with a client is broken. For many who did not need the relationship services, this is a good thing. You get anonymous wholesale execution and low prices, but for those that need support for market analysis, the service is not present. 


I make no value judgment when I say the world has changed. Pricing for brokerage is sharper, but information flows may be worse. Information flow and color has always been a two-edged sword. The color you receive on the behavior of others comes at the price that your information may be seeping to competitors. Nevertheless, market anonymity causes fragmentation, uncertainty, and potential volatility at extremes. There is more unknown about competitor actions. In the new world, there is still a need for information flow, color, research, and execution services. It will just have to come through some other conduit.

Monday, July 17, 2017

When markets disrupt so does performance - June managed futures and outliers



What kind of month was June for CTA's? Well, you can look at the distribution plot of returns for the month to get an idea of the extremes. We created the QQ plot for the 377 firms that reported to the IASG database for June as of last week. This can be done for smaller more specialized samples, but we took the maximum set of data reported to IASG. 

A QQ plot is a comparison of the quantiles of a set of data to test the distributional properties, specifically its uniformity. A uniformed distribution, like a normal, will find data on the straight line. 

It was a bad month for many CTA's with much larger than expected loses and with a negative skew or tilt, yet there were some clear winners for the month. The power of diversification and the wide choice among managers shows that not all CTA's are alike even within some standard classifications. Some of the big winners were associated with commodities which did not suffer from the whipsawing seen near the end of the month in equities nor the change in bond direction. Bigger losers were those firms focused on trends in financials. Interestingly, many of the poor performers were also hitting max drawdowns. While more formal distribution tests reject normality, the performance numbers were often consistent with 10% annualized volatility, but a locational mean that was much lower than expected from historical averages. The spread was expected, the average was not, and a few headline at the negative extreme. 

Sunday, July 16, 2017

Suffering from regret in the hedge fund world - A problem for all investors



We have learned from behavior finance that one of the key thing that investors do not want to suffer from is regret. From prospect theory, there is a desire to sell winners and hang onto losers in order to avoid regret not suffer from loss aversion. Loss aversion tied everywhere to the decisions we make. Picking the wrong manager. Picking the wrong strategy. Picking the wrong time to enter or exit a trade.  Investors do want to make a decision only to find out that ex post it was a poor one.

So when will regret be greatest for hedge fund strategy decisions? It should be tied to the dispersion in returns. If there is a wide spread between the best and worst strategy, there will be greater regret that the action taken could have been wrong. Similarly, there will be more loss aversion or regret for strategies that bounce around from the best returns to the worst. A hedge fund strategy that has more change in their strategy rankings may need higher returns to entice investors to hold given there may be regret. 

We have looked at the dispersion of returns in the Eurekahedge data base of hedge fund strategies from 2000 through the first half of 2017 to get some idea of the dispersion in performance and the potential for regret.




The maximum and minimum of hedge fund strategy returns have declined since the financial crisis. The minimum returns for strategies have hovered around zero and the maximum has fallen closer to ten percent. The dispersions of hedge fund returns across strategies have fallen over the last few years, but the important number is the wider dispersion if there is market turbulence or a crisis. Picking the right hedge fund strategy becomes all the more important when equity markets sell-off and there is a increase in correlation across asset classes. 

However, the data get very interesting once you move to strategy specific analysis. We conducted a simple analysis by asking the question, "How many times is a strategy the best performer or the worst performer in a given year?" We are looking at nine strategies over 17 years, so there are a total 34 best and worst events. All things equal, there is a 1/9 chance that a strategy will be worst in any given year. Clearly, more volatile strategies are more likely to be the best or worst, but we want to focus on the potential for regret. 

If you pick the best what is the likelihood of that strategy being the worst, or what is the chance of being the worst for any hedge fund choice. This can be explored more deeply, but I present just the counts for best and worst. The winner for most times being at the extreme is managed futures followed by distress. Four strategies have three times been the worst. Only managed futures had been five of seven times the worst performance strategy. Distressed followed by managed futures had the most frequent number of best strategy performance. 

Given the extreme good and bad performance for managed futures (CTA's), there may be a wariness by investors relative to multi-strat or macro which are more likely to always be in the middle of the pack with performance. A focus on regret is real given the chance to end up "wrong" with a strategy choice.

Using hedge pricing as a weapon - the firms with scale will squeeze smaller firms


The idea that hedge funds are getting 2/20 for management fees is becoming a myth. Dynamic pricing is being used more aggressively by hedge funds with a wide range of management and incentive fee options. For example, in the managed futures space, there seems to be a willingness to offer beta products as low-cost alternatives as well as traditional alpha plus beta products. The low cost products are being marketed as trend-following beta at low cost while higher priced products are being offered as alpha generators relative to trend-following beta. Of course, there is not a clear definition for what is trend-following beta so there is something more going on with this pricing. (The beta may be associated with a peer index, so the beta firms offer a low cost product to match a bundle of competitors.) This approach is being used by a number of larger firms.  

Since smaller firms have been shown to perform better than larger firms, lower fees by large firms help to cut the return edge associated with smaller firm. Secondly, lower fees after fixed costs are covered will create a barrier to entry for new firms who have to grow to break-even. Lower fees will mean a higher breakeven AUM is necessary to turn a profit. As the break-even level of AUM is raised, marginal firms are forced out of business unless they can consistently generate incentive fees to cover fixed costs. Additionally, it will harder for smaller firms to charge premium prices if the market fees are moving lower. This approach is extremely disruptive to the market structure as we believe that this pricing is being used more and more as a weapon to stop entrants and create barriers to entry. Now some of this pricing is not conscious action since for large allocations the investor sets the price, but changing the product mix, a willingness to negotiate prices, and lower posted prices all have impact on competitors. 

While any marginal dollar is valuable for smaller firms, the profit for firms will fall if the costs of marketing does not decline but the market price for management services is lowered. None of this should be news or surprising, but the economics of scale and pricing is becoming more relevant as returns from hedge funds move lower and the dispersion of returns compress. As the hedge fund industry moves from high new growth to taking market share from other firms, pricing as a tool for firm growth will become more sensitive to the impact of others. This is good news for investors, but bad news for the upstart firm who may thing that a good investment idea and hard work by itself will lead to success.

Friday, July 14, 2017

AUM growth as a signal of hedge fund quality - Is the investor herd right?


It is hard to determine whether one manager is better than another when looking at performance numbers. The sample sizes are often too small to distinguish return differences, so investors often looking for other signals that can be used to suggests one manager is better. One that is often used is growth of AUM. Call it the "wisdom of crowds" signal. If an investor cannot distinguish the return performance between two managers, he will place weight on the dollar opinion of others. If the herd is investing in manager X, perhaps they know something that others don't. The investor will free ride on the due diligence of others and invest with the manager who is growing faster. 

Unfortunately, this wisdom is a noisy signal. Growth may tell us something about past performance, but it may not be an indicator of future gains. It could be just dollar votes for past gains. There also is a strain of literature that past performance is not predictive of the future because the flow of funds will generate diseconomies of scale. There has been shown a link between past performance and the flow of funds, but we are asking a deeper question of whether fund flows tells us something about future performance that is not included in the past numbers. Additionally, is a growth strategy a tool by the management company to signal quality?

We believe that managers want to grow assets for a number of reasons beyond just the immediate gain of added revenue. Growth may signal quality, so managers will be willing to cut fees in order to grow and show the market there is strong demand for their services.  Discounts in price and the added cost of aggressive marketing may lead to a positive feedback loop that will generate more new revenue. Given this signaling effect, managers may be willing to suffer the risk of some diseconomies of scale and forgo maximizing income over the shorter run in order to generate the quality signal. 

This signaling is especially important if performance is within some tight range relative to other managers. 
  • Growth at any cost is important for the small manager who wants to break-out from the pack of other small managers where the dispersion in returns is large. In this case, aggressive pricing and terms are used to gain the AUM signal even though costs for running the firm may not be fully covered. Spending on marketing is critical. 
  • For the medium size manager, who may have already covered costs, high growth can accelerate investor interest even if performance is similar to other firms. Here, a strong marketing budget may eat into profit margins but generate longer-term business gains. 
  • Large firms who have limited worries concerning fixed costs should continue to aggressively market products in an effort to popularize the firm for new alternatives and revenue. Given economies of scale, marketing is a inexpensive way of add revenue in a measured manner. Fee revenue may be more important than incentive optionality. Similarly, firms will work hard to maintain AUM to avoid the negative signals associated negative growth.
The link between asset growth and signaling may seem obvious for some marketing experts, but we believe this is especially critical when product quality via returns is harder to distinguish. To date, we do not believe that growth-pricing strategies with hedge funds have been fully explored as signals beyond performance.  

Is the herd right? This is a testable hypothesis. Do above average money flows signal better future performance after accounting for any past return effect?  Even a weak signal of quality is worth exploiting, if past performance is also a noisy signal and future relative returns are uncertain. 

Thursday, July 13, 2017

Trend-following - A century of data suggests there is value


Consistency is critical for any investment style or factor, and it seems that trend-following seems to show it better than most other alternative strategies. It is now almost amusing that when efficient markets ran supreme as the paradigm of choice for market behavior no one was able to find these results, but now that there has been a shift in our views the scales have been lifted from our eyes and we find trend following is accepted through the ages. See the latest research from AQR Capital Management, "A century of  evidence on trend-following investing." which has been updated through December 2016.

I will not say that trend-following is perfect for all times, but the evidence says that it is an effective core strategy that can always be used by any investors. Prices are primal and their trend behavior is a good foundation for any discussion how to form an effective portfolio.

The research numbers shows that trend-following is effective across all major market sectors and long time periods. The Sharpe ratios net of fees are all positive for every decade since the 1880's. Additionally diversification with equities is strong with correlation with stock indices ranging between -.34 and .33. Both short and long-term trend-following is effective but not necessarily at the same time. The research shows that long-term trend-following is not sensitive to a lagging or delay of the signals. 

There is consistency with the benefits from trend-following which just reinforces the same story that marketers of managed futures funds have been using:
1. There is a non-liner relationship with equity returns, a performance smile whereby trend-following does better during market extremes.
2. The trend-following portfolio will do well during times of market stress. The research focuses on comparison between trend-following and a 60/40 stock/bond mix which is more representative of an investor's portfolio than 100% equities. Trend-following will add return at critical times.
3. When added to a 60/40 stock bond portfolio, trend-following will add return, chop volatility, improve the Sharpe ratio, and cut the maximum drawdown.






Questioning current trend-following performance should be expected, but location decisions should be based on prior evidence. The current drag on performance form holding a trend-following manager is real, yet the long-term evidence suggests that a trend-following is useful and patience should be a guide when making allocation changes. 

Wednesday, July 12, 2017

Is "directional volatility" needed for trend followers?




What is needed is volatility coupled with price trends, which Ivarsson refers to as “directional volatility”. “What we at RPM look for is ‘directional volatility’, meaning volatility that drives markets in a certain direction”. - RPM’s executive Vice President Per Ivarsson


The concept of directional volatility is elusive. It combines two concepts, the path of prices with the price spread away from the average. The quote is focused on the critical need for a trend with volatility for trend-follower to profit. Volatility is necessary but not sufficient for strong trend-following profits. It is necessary to have prices move across a range in a discernible path, but a wide price range can still be without trends. Trends may occur if there is low volatility but the level of profits will be smaller and the trends will be harder to identify. 

The depiction of trend following as a look-back straddle is based on volatility and the ability of the trend follow to capture the range. The look-back option is the potential max that a trend follower may achieve for a single trade within a time span. Nevertheless, if we think of a stochastic process for a price series, we want a mean change plus wide dispersion. It is not enough to just have volatility, the journey expressed in the volatility is critical. 

We can graph the simplest case of a Monte Carlo simulation of a normal distribution with zero mean and a 10% annualized volatility to generate 10 paths for 252 days (one trading year) to show possible paths for prices. We have also included a set of paths with 10% volatility and a 5% annual mean. A given volatility does not ensure that that there will be a path that can reach extremes over simulated time period.  Though not surprising, a 10% volatility with zero mean will generate paths that look like there is no trend. However, there will also be some paths that do seem to generate trend behavior even though there is no mean. Similarly, the blue lines which simulate paths with a 5% annual mean show paths that do not seem to have any trends. Volatility will not guarantee you a path that will trend higher or lower. 


Directional volatility is good short-form phrase, but it is important to understand the parts that potentially can drive trends. Trend followers want spread in price but they need paths for profit.





Tuesday, July 11, 2017

ECB CISS index; there is no trend in stress - Be happy


Don't worry be happy and without stress. There is declining stress in the EU as measured by the ECB Composite Index of Systematic Stress (CISS). While there is a big disclaimer with the ECB risk dashboard that this is not a early warning system, the declining trend tell a story of stability. 

This index serves as a European equivalent of the stress indicators that are used by the Federal Reserve Banks; however, there is a greater emphasis on cross-claims country claims, flows, and banking risks. The CISS numbers tell us that Euro area stress has been less volatile and reaching all time lows after spiking during the BREXIT vote.  The US stress indices have also been trending down in 2017. This down trend is consistent with EU equity volatility measures.


The VSTOXX volatility index below has shown a consistent downtrend albeit there have been spikes that suggest liquidity may be at times be strained in equity markets.


The ECB should be likely influenced by these positive stress numbers. A tapering of bond purchases would seem natural given the current state of stress, the lowered deflationary fears, the lower unemployment in most countries, and positive growth. A tilt to a policy change seems appropriate. Unfortunately, global macro managers who often thrive on stress and market dislocations have not fully taken advantage of this less stressful environment. 

Monday, July 10, 2017

"Icarus Trades" - Are these something to worry about?


We have heard the term "Icarus Trade" recently popping up in market discussions a number of times. Icarus, in Greek mythology, creates wings to fly but his overconfidence took him too close to the sun where his wings burned and he fell back to earth.  In investment terms, the overconfidence of some investors will take them to market extremes only to suffer a fatal fall as the market normalizes. As markets go to extremes, a position can turn into an Icarus Trade. Call it a variation of a crowded trade. As the market moves to valuation extremes, investors are more likely to get burned and sent back to earth. This is a nice story, but is it true? Narratives should not beat reality. 

I can argue that this is testable. In equity space, as markets move to more extreme valuations, the downside risk may get larger, so high valuation may see more negative skew in the future distribution relative to non-extreme periods. High valuations should be associated with a change in the distribution with potentially more downside risk. Of course, we could form a test for this except there is a simple problem. What is a high valuation? We need to know this ex ante and we need to be able to set some bounds on the test period. Finally, we need a sample of potential Icarus trades which could be anyone's guess.  

Icarus got burned because he was not able to measure being too close to the sun. At what point does being too close to the sun occur? For equity holders, did it occur yesterday or will to be tomorrow? Has it occurred for tech investors? What about bond investors? This problem can be closely related to two approaches to trade management. For those that can measure value, you get out when the market moves to overvaluation. For those that cannot measure value or believe it is too uncertain, the simple rule is to hold onto winners and only reverse after the price direction changes.  Rules for behavior can be engaged. However, be aware of the false narrative that sounds illustrative but has no foundation in the solid number.

Friday, July 7, 2017

Global macro on one-page - All about central bank balance sheet issues


What will be the key driver for global macro portfolios in the second half of the year? I hate to say it, but it will again be central bank behavior. I thought there was a switch to focus on the real economy with the Fed starting to raise rates and react to the macro environment, but markets seem to be deeply focused on how normalization and central bank sheets will be adjusted. 

We are getting a taste of the new world with strong bond market sensitivities to any suggestion of an ECB change. It may not be a taper tantrum, but there is a new caution with holding bonds. This bond caution will carry-over to other risky assets. Simply put, the financial asset rallies around the world were driven by liquidity and leverage and now the liquidity environment is changing. The adage for markets have always been, "don't fight the Fed" when it is adding liquidity. The same philosophy should apply in the opposite direction, "don't fight central banks if they are going to normalize." Leverage is out and risk taking should be more prudent. This process of market switching to normalization may not be immediate or dramatic, but should be in the minds of all investors.

Thursday, July 6, 2017

Most stocks are losers - Median and skew tell an important story


Most stocks do not do well over their lifetime. If you randomly pick a stock or set of stocks there is a high likelihood you will not do better than T-bills and you will likely not survive for a long time. This should be well-known, but a new research paper really present some stark conclusions. This is a paper that is insightful and sobering for most investors. See "Do stocks Outperform Treasury Bills" by Hendrik Bessembinder

While the conclusion are based on the well-used CRSP database, this work has not be done before or has not been highlighted in basic discussions on stocks. It is sobering because it tells you how difficult it is to make money by holding a stock portfolio. There are few papers that you will read this year that will change your view of stock investing as much as this fundamentally simple work. What is most important is that this research should change your priors on what are the risks from holding stock and simple fact that buying stocks can be a lottery ticket of poor returns coupled with a few out-sized skewed winners. 

A cross-sectional review of stock performance shows that the distribution of returns is positively skewed, but 58% of all stocks will underperform 1-month T-bills over their lifetime and only about 4% of all stocks, the best performers, will account for all of the gains in the market. A key driver is that most stocks do not last a long-time, on average, seven years. There is a lot of risk when compounded equity returns are not normal, but the power of compounding is critical for generating long-term wealth.

These performance dynamics are all driven by the mechanics of skew. Compounding returns generates positive skew and the traditional focus on mean and variance masks the impact of differences between the mean and median returns for stocks. Most stocks will be losers in any month and across their lifetime. Only a few will be significant creators of wealth. If an investor is not fully diversified, he may come up a loser because he is just not holding the few winning lottery tickets in equity markets. 

One could argue that holding passive indices is critical because you just don't know who will be the few positively skewed winners. Alternatively, the active managers will say that this research suggests that insight is needed to look for these few winners. I will leave this discuss to others, but the critical issue is that risks may be larger that what many have imagined and that premiums are necessary given the risks faced.