1/ When Diversification Fails (Page, Panariello)

"To fully appreciate extreme correlations, we take an in-depth look at stock-to-credit, stock-to–hedge fund, stock-to-private asset, stock-to-factor, and stock-to-bond correlations during tail events."

2/ "For each pair, we simulated two normal distributions using empirical full-sample correlations, means, & volatilities."

"Empirical correlation profiles differ substantially from their normally-distributed counterparts: International diversification works only on the upside."
3/ "We found similar results across risk assets.

"We use bond returns net of duration-matched U.S. Treasuries ('excess returns') to isolate credit risk factors.

"Across the board, left-tail correlations are much higher than right-tail correlations."
4/ "All the hedge fund styles, including the market-neutral funds, exhibit significantly higher left-tail than right-tail correlations.

"A simple explanation could be that most hedge fund strategies are short volatility. Some are also short liquidity risk."
5/ "Not only is the true equity risk of private assets higher on *average*, but left-tail exposures are also higher.

"Annual correlations are less sensitive to smoothing: reported quarterly returns for private assets represent a moving average of true (unobserved) MTM returns."
6/ "Again focusing on diversification vs. U.S. stocks, several L/S risk factors indeed appear to be more immune to the failure of diversification than are asset classes.

"This may result from the removal of the long-only constraint and the expansion of the investment universe."
7/ "Duration risk may be the only true source of diversification in multi-asset portfolios.

"But when inflation and interest rates drive market volatility more than business cycles and risk appetites do (the 1970s and 1980s), the stock–bond correlation often turns positive."
8/ "We then estimated the stock–bond correlation as a function of percentiles in *bond* returns instead of stock returns.... the correlation profile is now not as desirable.

"Although the correlations are generally low, when bonds sell off, stocks can sell off at the same time."
9/ "Caveat: this represents only one way to measure diversification. Conditional betas, for example, take into account changes in relative volatilities as well as correlations.

"We recommend that investors avoid the use of full-sample correlation in portfolio construction."
10/ "Scenario analysis, either historical or forward-looking, should take a bigger role in asset allocation than it does.

"Tail hedging, L/S factors, defensive momentum, and dynamic volatility targeting provide better left-tail protection than does traditional diversification."
11/ Related research:

The Impact of Volatility Targeting

The Death of Diversification Has Been Greatly Exaggerated
12/ Strategic Allocation to Commodity Factor Premiums

Demystifying Illiquid Assets: Expected Returns for Private Real Estate
13/ In the paper Investing with Style, Asness et al. found that factors constructed in a very diversified way provided helpful performance during the worst 10% of months for global equities:

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More from @ReformedTrader

12 Jan
1/ What Happens with More Funds than Stocks? (Madhavan, Sobczyk, Ang)

"Funds differ meaningfully in terms of individual stock holdings, and we examine the factor exposures of the typical fund and the cross section of holdings of different funds."

papers.ssrn.com/sol3/papers.cf… Image
2/ * Data on fund holdings are from Morningstar
* Sample: Jan. 1, 2007 to Dec. 31, 2018
* Only funds with at least 80% of holdings from the Russell 3000 universe are considered
* Mean AUM-weighted expense ratio for mutual funds (ETFs) is 70 bps (14.2 bps) as of Q4 2018 ImageImageImage
3/ "The holdings of ETFs and active mutual funds across U.S. stocks can be efficiently summarized by approximately 10 canonical funds.

"There is more commonality explained by the first few canonical funds for active mutual funds than for ETFs." ImageImage
Read 9 tweets
12 Jan
1/ Research group meetings: Pros and cons

These are the ones where a paper/book/project is openly discussed and criticized.

Their dynamic is present in very few places (scientific research, theological debate, close friendships). IMO, most organizations have no idea it exists.
2/ Pro: They are great if you avoid groupthink. Always have someone other than the boss present so that dissent doesn't become associated with career risk.

Pro: This setting flattens organizations. If you have an idea, speak up: don't bother raising your hand.
3/ Pro: A good boss loves getting criticized here. If you get in a friendly argument with him in a safe setting and win, you've shown you can add something to the organizations' research efforts.

Pro: It's hard for people to get away with fudging ideas. Always present evidence!
Read 9 tweets
10 Jan
1/ Institutional Gold (Parikh)

"Gold’s correlations are sensitive to the investor’s horizon and time period. We discuss the difficulties of estimating correlations (especially for long horizons) and the importance of measuring estimation uncertainty."

2/ * Futures include cash returns
* Rolls to contract with the most favorable carry or (if carry is negative) to a simulated gold ETF with 40 bps/y expenses
* Using this roll strategy has 7.1%/year returns vs. 4.8% for rolling monthly

More on this here:
3/ "Gold might serve as a long-term hedge against economic slowdowns, was the only asset to have negative correlation to equity at the 90th percentile for 5y horizon returns, and (of all the assets) was the most diversifying to Treasuries."
Read 8 tweets
5 Jan
1/ Will My Risk Parity Strategy Outperform? (Anderson, Bianchi, Goldberg)

"We gauge the potential of four strategies: value weighting, 60/40, unlevered and levered risk parity. Costs can reverse the ranking, especially when leverage is employed."

papers.ssrn.com/sol3/papers.cf… Image
2/ * U.S. stocks and U.S. Treasury bonds are inverse vol weighted (36-month rolling estimates)
* Monthly rebalancing
* Leveraged risk parity targets the ex post volatility of the market portfolio
* Trading costs are assumed to be 1% (1926-55), 0.5% (1956-70), and 0.1% *1971-2010) ImageImageImageImage
3/ "From 1926-2010, levered risk parity (financed at the 90-day T-bill rate) had the highest return. However, the performance was uneven."

NOTE: The U.S. stock/bond portfolio (no commodities) studied here may not be sufficiently diversified across asset classes. ImageImage
Read 9 tweets
4 Jan
1/ Option Trading Costs Are Lower than You Think (Muravyev, Pearson)

"Options price changes are predictable at high frequency. Effective spreads of traders who time executions are less than 40% of the size given by conventional measures."

2/ * Trades and intraday bid/ask at one-minute frequencies for all U.S. listed equity options and the underlying stocks

* Option trades ≤ 10 cents, trades for which trade direction cannot be determined, and trades during the first and last five minutes of the day are removed
3/ "Conventional measures of transactions costs are large: The effective spreads are about 80% of the size of the quoted spreads. The price impacts are also large.

"ITM options have relative (dollar) spreads that are smaller (larger) than those of options in the full sample."
Read 17 tweets
4 Jan
1/ Term Structure of Short Selling Costs (Weitzner)

"Forward short selling costs (derived from put-call parity) predict future costs and stock returns. Short selling costs are higher over horizons when negative information is more likely to arrive."

2/ * Dividend payers excluded
* Cost of shorting (median across strikes) over the term of the option is back-calculated using synthetic relationships, then forward rates are calculated
* Options with negative implied shorting costs are excluded
* Spot lending data is from Markit
3/ "If earnings announcements are periods when negative information is more likely to arrive, then the term structure's shape should be affected by when an announcement takes place.

"Options that expire after the earnings announcements do have higher annualized shorting costs."
Read 11 tweets

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