Eric Falkenstein 1

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 2

about Risk, Return, and Alpha I’m an economics PhD who has worked as a quant, risk manager, and portfolio manager falkenblog.blogspot.com 3

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 4

After 45 years, there are no measure of risk that are generally positively correlated with returns Fama and French

Theory: Longer hair people are short Omitted variable: gender Theory: high beta firms have high returns Omitted variable: size

Fama-French rebrand ‘anomalies’ as ‘risk factors’ No anomalies! 7

Oil prices Consumption growth Per-capita labor income Consumption/wealth ratio Statistical (latent) Factors Etc. 8

"Risk is not an add-on … it permeates the whole body of thought.“ Robert C. Merton 9 “most returns and price variation come from variation in risk premia” John Campbell

Finance is “the only part of economics that works” Andy Lo finance  economics > sociology 10 Derivatives: risk neutral expected value Efficient Markets: hard to make money

‘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 11

75 % of finance professors would recommend using the CAPM for capital budgeting, 10 % the Fama-French model, 5 % some unspecified APT Why use it? 1) CAPM ‘works’ if we ignore small firm effect 2) Everyone (ie, academic finance) does it 3) What else should we do? 4) Intuitive (it should work) 12 Ivo Welch

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 13

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 14

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Low vol Low beta Profitable Unlevered High vol High beta Unprofitable levered “Risky?” “Safe?” “Beautiful?”

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 17

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 18

“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 19

“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 20

People pay for hope  highly ‘risky’ assets generally have lower returns Lottery returns high vol stocks Junk bonds Etc. 21

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 22

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 23

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. 24

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 25

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! 26

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! 27