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Finding Alpha. Eric Falkenstein. Risk and Return. In general, risk is not related to return At very low risk, there is a positive risk-return trade-off effect At very high risk, there is a negative risk-return trade-off. Who am I and What This Is. about Risk, Return, and Alpha

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## Finding Alpha

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**Finding Alpha**Eric Falkenstein**Risk and Return**• In general, risk is not related to return • At very low risk, there is a positive risk-return trade-off effect • At very high risk, there is a negative risk-return trade-off**Who am I and What This Is**• about Risk, Return, and Alpha • I’m an economics PhD who has worked as a quant, risk manager, and portfolio manager • www.defprob.com • www.efalken.com • falkenblog.blogspot.com**Risk has been my Hobby Horse**• TA for Hyman Minsky in 1986 • Risk essence of interesting economics, undefinable • 1994 dissertation documented volatility and returns inversely related • Scope of evidence accumulating to a critical point • Present theory why risk not related to return in general**The Problem**• After 45 years, there are no measure of risk that are generally positively correlated with returns Fama and French 1992**Theory:**• Longer hair people are short • Omitted variable: gender • Theory: • high beta firms have high returns • Omitted variable: size**Response to CAPM Failure**• Fama-French rebrand ‘anomalies’ as ‘risk factors’ • No anomalies!**Snipe hunt for factor that works**• Oil prices • Consumption growth • Per-capita labor income • Consumption/wealth ratio • Statistical (latent) Factors • Etc.**Praise for a Vacuous Theory**• "Risk is not an add-on … it permeates the whole body of thought.“ Robert C. Merton “most returns and price variation come from variation in risk premia” John Campbell**Still Considered The Gold Standard**Finance is “the only part of economics that works” Andy Lo finance > economics > sociology Derivatives: risk neutral expected value Efficient Markets: hard to make money**Praise for a Vacuous Theory**‘it would be irresponsible to assume that [the CAPM] is not true’ William Sharpe ‘theoretical tour de force’ though ‘empirically vacuous’ Eugene Fama ‘stochastic discount factor(s) … so general, they place almost no restrictions on financial data’ John Campbell**Praise for a Vacuous Theory**75 % of finance professors would recommend using the CAPM for capital budgeting, 10 % the Fama-French model, 5 % some unspecified APT Why use it? • CAPM ‘works’ if we ignore small firm effect • Everyone (ie, academic finance) does it • What else should we do? • Intuitive (it should work) Ivo Welch**Intuitive**• Risk aversion like aversion to smelliness • Is mathematically consistent • Given assumptions, asset pricing theory is correct • CAPM special case of APT and SDF theory • Like physics: mathematical beauty leads to truth**…And Wrong**• Leveraged Firms • B vs. BBB rated Bonds • Out-of-the-money options vs. at-the-money options • S and C corps vs. equity indexes • Highest volatility vs. modest vol stocks • R rated movies vs. G rated movies • Lotto vs. ‘quick pick’ lotteries • 50-1 horses vs. 3-1 horses • Mutual funds, currencies, futures, countries, yield curve**We can mathematize it: maximally attractive female**waist-to-hip ratio around 0.7 physical beauty we can ‘see’**If Risk is Priced, It's like Modern Art**High vol High beta Unprofitable levered Low vol Low beta Profitable Unlevered “Safe?” “Risky?” “Beautiful?”**Essential, Undefinable**• Nobody charges differently for capital within a bank • Mortgages • real estate • credit cards • Hedge fund: funding rates the same for • distressed lending • Convertible bonds • pairs**My Theory**• Relative Utility no general risk premium • Instead of maximizing income, where each dollar is worth less to us, we maximize our status. • All risk like idiosyncratic risk, unnecessary so unpriced**Everyone Benchmarks**• “I want a product to be defined relative to a benchmark” Bill Sharpe • ‘Risk, see Benchmarking’ Kenneth Fisher’s Only Three Questions that Count • “small stocks were in a depression” in the 1980’s Eugene Fama**Everyone Benchmarks**“I visualized my grief if the stock market went way up and I wasn’t in it—or if it went way down and I was completely in it. So I split my contributions fifty-fifty between stocks and bond” Harry Markowiz**My Theory**• People pay for hope highly ‘risky’ assets generally have lower returns • Lottery returns • high vol stocks • Junk bonds • Etc.**Why pay for risk?**• Optimal search theory • Stopping problem • Sample many times, choose best • Find your competitive advantage implies some failure • Fail 90% of the time • Once you succeed and play again and again • Education is about finding what you are good at, getting better at it, doing it again and again • Bad ‘rule’ for passive investing**My Theory: Risk Premium Does Exist**• People apply a risk premium when there is zero alpha and they have to play super low risk assets have low returns (eg, cash) AAA-BBB spread 3 month to 1 year in Treasury Bill maturity Equity Risk Premium for efficient investors No chance for alpha, because idiosyncratic volatility so low**Equity Premium**• Geometric vs. Arithmetic Averaging 3.0% • Survivorship Bias/Peso Problems 3.0% • Post WW2 Reduct. in Eq. Premium 3.0% • Taxes 2.0% • Adverse Market Timing 2.0% • Transaction Costs 2.0% • Sum 15.0% • Most estimates around 3.5% for equity premium. With these additions, the Marginal Investor clearly could be seeing a 0% equity premium.**Alpha Examples**• Invariably backward looking • Strategies that have generated alpha • Convertible bond arbitrage • Pairs trading • Convexity trade • Not super mathematical, but very detailed • Specific strategies with prospective alpha • Index investing • Beta arbitrage**Effect of Miasma: Alpha Games**• Alpha is private information, valuable • Force big ideas it down people’s throats • Be sensitive about revealing small ideas • Financial politics uses alpha as the key pretext • Someone paid $500k, $5MM, $50MM because they present alpha • Politics are not inversely proportional to the stakes!**Some Implications**• Take risks finding your comparative advantage • Sample things, expect to pay to take such risks • Don’t take risk investing in above average volatility assets within any asset class, unless it’s a search for a comparative advantage • Don’t ‘risk adjust’ returns—Just like derivatives!

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