There’s a Reason for Risk Premiums

 

Recently I ran across an academic journal article where they posited one dozen or so risk premiums that were durable, could be taken advantage of in the markets. In the past, if you had done so, you could have earned incredible returns.

What were some of the risk premiums? I don’t have the article in front of me but I’ll toss out a few.

  • Many were Credit-oriented. Lend and make money.
  • Some were volatility-oriented. Sell options on high volatility assets and make money.
  • Some were currency-oriented. Buy government bonds where they yield more, and short those that yield less.
  • Some had you act like a bank. Borrow short, lend long.
  • Some were like value investors. Buy cheap assets and hold.
  • Some were akin to arbitrage. Take illiquidity risk or deal/credit risk.
  • Others were akin to momentum investing. Ride the fastest pony you can find.

After I glanced through the paper, I said a few things to myself:

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  • Someone will start a hedge fund off this.
  • Many of these are correlated; with enough leverage behind it, the hedge fund could leave a very large hole when it blows up.
  • Yes, who wouldn’t want to be a bank without regulations?
  • What an exercise in data-mining and overfitting. The data only existed for a short time, and most of these are well-recognized now, but few do all of them, and no one does them all well.
  • Hubris, and not sufficiently skeptical of the limits of quantitative finance.

Risk premiums aren’t free money — eggs from a chicken, a cow to be milked, etc. (Even those are not truly free; animals have to be fed and cared for.) They exist because there comes a point in each risk cycle when bad investments are revealed to not be “money good,” and even good investments are revealed to be overpriced.

Risk premiums exist to compensate good investors for bearing risk on “money good” investments through the risk cycle, and occasionally taking a loss on an investment that proves to not be “money good.”

(Note: “money good” is a bond market term for a bond that pays all of its interest and principal. Usage: “Is it ‘money good?’” “Yes, it is ‘money good.’”)

In general, it is best to take advantage of wide risk premiums during times of panic, if you have the free cash or a strong balance sheet behind you. There are a few problems though:

  • Typically, few have free cash at that time, because people make bad investment commitments near the end of booms.
  • Many come late to the party, when risk premiums dwindle, because the past performance looks so good, and they would like some “free money.”

These are the same problems experienced by almost all institutional investors in one form or another. What bank wouldn’t want to sell off their highest risk loan book prior to the end of the credit cycle? What insurance company wouldn’t want to sell off its junk bonds at that time as well? And what lemmings will buy then, and run over the cliff?

This is just a more sophisticated form of market timing. Also, like many quantitative studies, I’m not sure it takes into account the market impact of trying to move into and out of the risk premiums, which could be significant, and change the nature of the markets.

One more note: I have seen a number of investment books take these approaches — the track records look phenomenal, but implementation will be more difficult than the books make it out to be. Just be wary, as an intelligent businessman should, ask what could go wrong, and how risk could be mitigated, if at all.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.