Structured / Quant Finance Boom Far From Over
(May 15, 2008)
Dear Subscribers and Readers,
On a year-to-date basis, the sales of Collateralized Debt Obligations (CDOs) slumped to $23.3 billion, down from $207 billion in the same period of last year. Many banks are still struggling to get rid of their hard-to-sell assets. However, given the unprecedented amount of investable capital sitting on the sidelines – whether it is tied in money market funds, distressed debt funds, or cash rich hedge funds, private equity funds, or sovereign wealth funds – I expect a significant amount of these structured finance products will be sold off and removed from the banks' balance sheets sometime over the next 12 months. The obstacle isn't the lack of capital, but the relatively low bids the banks are getting – primarily because investors still don't have a clear picture of where the U.S. housing market is heading over the next 12 to 24 months. Should a bill that provides tax incentives to first-time homebuyers be signed into law by President Bush – there is a good chance that a bidding frenzy will emerge for much of these assets, as many of them have been written down to a level that does not represent current economic reality. Once these assets are cleared from the banks' balance sheets, the U.S. financial sector will again be in a position to reliquify the U.S. and global economy.
Perhaps more importantly, Wall Street, along with its “quants” armed with new formulas and models, will again embrace financial innovation and seek to push high-margin products onto their consumers, including high net worth individuals, hedge funds, and pension funds, alike. Make no mistake: Wall Street is a sales machine first, even as it provides a very essential role to the capitalist economy. How fast and far this new era of financial innovation will go will depend on the political will of Congress and the regulators, but if history is any guide, financial innovation – accompanied by a continuation of the structured and quant finance boom – will soldier on.
The continuing popularity of quantitative finance, despite its latest missteps, cannot be overstated. In the book “Super Crunchers,” Professor Ian Ayres of Yale Law School discusses how many companies – not just financial services companies or quantitative hedge funds – have adopted various statistical techniques to better predict consumer behavior, track inventory and even forecast certain prices of consumer goods or box office numbers of upcoming movie titles. Obviously, forecasting tools such as regression techniques are not new (the concept of “least squares” goes back to at least the 18th century), but what has made these tools more popular is the accessibility of raw computer power and storage space, not to mention the fact that in many cases, making a decision based on some kind of quantitative method has generally resulted in more optimal solutions. Even within the financial markets – where there is no closed-form solution (because none of us making the forecast can be entirely detached from the markets) – a trading system based on some kind of rigorously tested quantitative system, typically results in much more optimal investment results than simple human intuition (for the majority of investors) over the long-run.
Ultimately, it doesn't really matter what you, dear subscriber, or I think. Corporate entities and institutional investors alike are demanding more quant based forecasting. They have come to expect it, especially given the continuing increase in computing power, better data sets, and the supply of financial/business talent that also possesses a high-quality quantitative background (case in point: the UCLA Anderson business school just launched its Master of Financing Engineering Program a couple of months ago). Within the institutional investment management world, investors have continued to demand more exposure to quantitative equity/fixed income strategies as well as hedge funds.
With this framework in mind, let us now discuss what we see in the future for the investment management industry. Robert Litterman, a Managing Director at Goldman Sachs and Chairman of Goldman Sachs Asset Management's (GSAM) Quantitative Strategies Group recently discussed (in the latest CFA Quarterly Proceedings) the difficulty in achieving investment “alpha” - and postulates that a much easier way of achieving excess returns may be through a concept known as “exotic beta.” He defined the term “exotic beta” and compared it to pure “alpha” in the following two paragraphs of this article:
The term “beta” is used in two different ways. Originally, academics who were writing in the CAPM context used the term to mean exposure to the market, and alpha was considered whatever was left. But more recently, the term has come to be used in a more generic sense to mean the exposure to any risk factor, such as the beta to commodities. In this context, the term does not mean that commodities have a market beta but, rather, that the investor has an exposure to commodity risk. So, exotic beta now refers to the passive exposure to a risk factor or an asset class other than the market. (I will use the term “market beta” to refer to the classic CAPM exposure to the global market portfolio.) For risk factors or asset classes in which a passive exposure is expected to produce returns above the equilibrium level (for example commodities, in which case the equilibrium level is essentially zero), that exposure, which we call “exotic beta,” is considered a source of alpha.
Adding the term “exotic beta” allows investors to think about sources of return in terms of a spectrum, beginning with pure market beta. The properties of market beta include low cost and unlimited supply, but expectations for the return per unit of risk (the Sharpe ratio) are currently relatively low. For example, a portfolio that depends on market beta may have a 3.5–4 percent equity risk premium and generate a total return of about 8 percent. Exotic beta can arise from a largely passive exposure to less mainstream asset classes, such as high-yield bonds, global small-cap equities, emerging market equities, emerging market debt, commodities (obtained by rolling futures contracts), and global real estate. These exposures have the advantages of relatively large capacity, enhanced return potential, and low correlation with market beta, but they are likely to be more costly to implement than market beta. Active alpha is defined as the ultimate return source derived from skilled active management and consisting of risks that are uncorrelated with the market. The downside of active alpha is that it is difficult to find and expensive to implement because of management fees and trading expenses.
In other words, hedge fund and mutual fund managers alike can easily “goose up” their returns without much additional risk by investing in less mainstream and out-of-benchmark asset classes and label those returns as “alpha,” even though technically, these excess returns should be labeled as “exotic beta.” For a hedge fund manager who charges “two-and-twenty” and who is focused on quarterly performance, such a strategy is infinitely more attractive than a strategy based on pure stock picking or market timing. At the very least, such a strategy would allow the hedge fund manager to spend time on his favorite hobby – whether it is on his wine/exotic car collection, or flying to see the Final Four game on his own private jet! For a fixed income manager, such a strategy (such as buying emerging market debt over the last few years) could have easily added an incremental annual rate of return of 25 to 50 basis points. In the fixed income world, an outperformance of 50 basis points over the long-run would put you in the upper echelons of fixed income managers. GSAM defines the “market portfolio” in the following chart:
Figure 1 shows a breakdown of the market-cap weights that we use at Goldman Sachs. I do not want to defend a particular measure of the market portfolio. Let me simply raise some issues, such as what the market-cap weight should be for commodities. Is it zero, as noted in the figure, or should it be a positive number? The case for zero would be that commodities are owned by corporations, so they are already included in the equity allocation. Also, most investors invest in commodities through derivatives, which have no impact on net supply because the underlying commodities are already owned. A case for a positive number could be that much of the market value of the world's commodities is in oil, and because most oil is owned by governments, much of its value is not captured in global equity. As a result, some investors might want to use derivatives to proxy for the government-owned oil missing from global equity markets. Another issue in the definition of the market capitalization is that these assets leave out human capital, which is viewed by some as the greatest source of wealth in existence. By the measure of market capitalization, human capital is not captured at all (except possibly to some degree by corporations). The ultimate question is whether this, or any, definition of the market portfolio is relevant to investment decisions.
Litterman than goes on and discusses other potential sources of “exotic beta,” highlighting a strategy based on selling volatility (historically, implied volatility has traded above actual volatility most of the time), style investing (such as buying “value” stocks vs. “growth” stocks, which we have also discussed in the past), or selling insurance (collecting premiums which are actuarially set above the expected loss rates).
No doubt, many hedge funds have already tried a mixture of these exotic beta strategies. For example, Long Term Capital Management was famous for systematically selling short volatility. Many long-short equity hedge funds engage in value strategies, while some hedge funds have even waded into the “Cat Bond” business by selling reinsurance on catastrophic events over the last few years. The “poster child” during the market cycle has been the hedge funds buying subprime CDOs to goose up their returns, hoping to take advantage of their illiquidity premium as well as the perceived advantage of their modeling capabilities (i.e. ever-rising housing prices).
In other words, even the strategies that Litterman just highlighted are now becoming saturated. Hedge funds will need to continue to seek newer and more fertile fields, such as the weather derivatives market. But there is a whole new world out there to be tapped. Litterman mentioned it himself when he stated:
Another issue in the definition of the market capitalization is that these assets leave out human capital, which is viewed by some as the greatest source of wealth in existence. By the measure of market capitalization, human capital is not captured at all (except possibly to some degree by corporations).
In his 2003 book “The New Financial Order,” Robert Shiller argues that most of the risks that we suffer as individuals today (such as losing one's job or choosing a dead-end career) will be hedgeable in the not-too-distant future. Shiller envisions a somewhat utopian world where finance (the age-old issue of risk management) is "democratized," i.e. a world where everyday individuals will gain access to a futures market that will allow them to diversify away every risk imaginable. As mentioned in a previous commentary (“A World of Financial Engineering”), Shiller presents the following six incredible ideas:
- The concept of livelihood insurance, where contracts will protect individuals from long-term economic risks such as the loss of a paycheck or the depreciation of one's home value.
- The concept of what he terms "macro markets" - where individuals, corporations, and governments alike can trade or hedge risks associated with the fluctuations in GDP or national incomes.
- The concept of income-linked loans - where lenders will make loans to governments, corporations or individuals whose repayment terms are tied to the incomes of these entities. Such repayment terms could be a certain percentage of one's income, which would cause the outstanding balance to decline if income levels decline. This would reduce the change of bankruptcies but will also alleviate our fears of taking more risks (such as changing careers). Shiller also addresses the potential "moral hazard" problem of this approach in his book.
- The idea of inequality insurance - which is designed to address the income inequality problem within a particular nation.
- Intergenerational Social Security - which will allow "genuine and complete intergenerational risk sharing" - as opposed to today's Social Security program (which is basically a pyramid scheme) in the United States today.
- International Agreements - which will allow sovereign governments to manage the risks of their own national economies - by sharing their risks with other sovereign governments.
A typical creation based on the above points would be a plain vanilla derivatives contract based on income levels of certain professional careers. Not only will these allow money managers to gain “investment exposure” to the value of the global human capital base, it will also provide valuable price signals (assuming an exchange-traded futures market for these contracts develop) for entering college students who have yet to decide on a college major. Moreover, it will also give us a good estimate of just how much our global human capital stock is worth. Obviously, there are many nuisances that we need to sort out – but in a nutshell, college students or entry-level workers could partially protect their future income/career path through a hedging strategy that utilizes these derivative contracts. The parties that take the other side of the contract will most likely be hedge fund managers or quantitative investors. With respect to the latter group, such a strategy will allow them to achieve outsized return simply because of the “exotic beta” nature of the strategy. This is not unlike investing in commodities during the 1950s to 1970s, when the folks who took the other side of the contracts were mostly risk-averse and unsophisticated farmers who were not engaged in return-maximization or risk-minimization strategies. While the latest crisis in the structured finance world is a setback for financial innovation, it is by no means a “knockout punch.” We are on an inevitable path to another explosion (no pun intended) in the derivative/structured finance/quant markets, like it or not.
Henry To, CFA