Volatility differences - watch small caps

Tracking volatility differences suggests that risk is increasing in the small cap world. While EM stocks have seen a fall in volatility, we are seeing small caps close the vol difference that has existed for the last year. The risk relative to the VIX index is also increasing. Relative risk differences are a good guide for what the market is thinking about sector uncertainty and risky sectors are seeing more uncertainty.

Discretionary trading - is there value with talking to the CEO?

Never pay the slightest attention to what a company president ever says about his stock.

 -Bernard Baruch

The same advice applies to government officials. Of course, there will be a reaction to what a company president says and what a central bank official will say, but that will only be short-term. The real action will be with what is actually done. What are in the numbers.

The focus on words leads to a whole set of behavioral biases. There is a confirmation bias associated with listening to companies. There is a false sense of confidence from having words with the CEO. What happens if the CEO is a good presenter or a poor presenter? CEO's often get their jobs by being charming.

Does it help the valuation decision? I don't think so. Assume you have a choice between data or the CEO conversation. There is no contest on what is more valuable. How can the talk be quantified or made into a repeateable decision process? It cannot work in a systematic fashion.

The bad arithmetic for pensions

If the expected rate or return or discount rate for a pension fund is 8%, you should ask what you need from equities to hit the target if you hold a 60/40 stock/bond mix and the current 10-year yield is 2.75 percent. 

The math is simple. For this year, you will need 11.5 percent from your equity portfolio. This does not seem like pleasant math. It only gets worse if the pension is underfunded and needs higher returns than  the expected rate of return.

 If equity returns decrease, there has to be a gain from the bond portfolio with rates going down. The worst case scenario is a decline in both equities and bonds which could come if we transition to higher inflation or we do not get the bond hedge from a negative correlation between the two major asset classes.

Many pensions understand this unpleasant math, so they have tried to adjust their portfolios to offset the poor value-added from the the bond allocation of their portfolio. The objective of moving to alternative investments is to counter the poor bond returns. This is the big pension bet that has caused all of the new flows.  In this context, the alternative portfolio has to beat the current bond yield of 2.75 at similar volatility. This actually may not be hard to beat for many alternatives; however, you have to include the value of negative correlation from bonds. The hedging value of bonds was significant during the market downturn. Consequently, there is needed a higher return on the alternative portfolio given the hedge value is not as strong. 

This story also assumes that the alternative allocation addition is coming from bonds. If the allocation is also coming from equities, the alternative returns have to be higher to offset the expected higher returns from equities. In a perfect world, if the alternatives gave a expected return close to the expected overall rate of return, it would be a preferred asset. But, producing an 8 percent expected return is pushing the envelope for many hedge fund strategies.

We are still in an unpleasant pension math world even when we have alternatives added to the portfolio.

Gold fixing - is it still needed?

The FT discusses whether the gold market needs a new standard for fixing the price of gold. This is an interesting issue given the problems with fixing of LIBOR prices, the manipulation of FX rates on fixes. Some banks may say it is not worth being involved with the gold fix even though the process has been round for over a century. 

Ultimately this is an issue of market design which has become a hot topic in economics. (It has become a hot topic across all disciplines in business schools.) Market design issues are associated with how to generate a thick market where many are willing to participate but still have it be safe from manipulation. Having a group of banks bring their order books together and determine a price when the market will balance is going to provide some information advantage to the fixing banks, yet having a blind electronic order matching system at a set time may lead to some disruptive surprises. There is an issue of trying to find a balance. Having review and suggesting some alternatives will be good for the market.