Sunday, September 26, 2010

Cheap money at the gates!

Indian equity markets have staged an impressive rally in the past couple of weeks. One major reason for this was the rather subdued growth in equity markets in last 6 months after the initial recovery. Once the markets caught up to the fundamentals (and probably went a little further), suddenly everyone seemed to be looking around for reasons to justify higher levels. There were not many and that showed in the range bound markets for last 6 months.

Interestingly nothing major has happened in the last month either. Domestically that is. Of course the monetary policy stance is becoming less aggressive, inflation is waning, IIP is rising and GDP forecasts are getting better. But none of this is 'news' and to that extent has largely been factored in the markets. The real change in my view is on the foreign investors' front. Many investors in the developed economies seem to be over their fears now and are back into the hunt for returns. The other thing that works in India's favor is the a robust economic growth through the crisis and absence of any obvious signs of bubble (unlike China). Thus the cheap money is at our gates again!

Is it a problem? Not now, not necessarily in future either. But it can be worrying for us in two ways. For one, the returns that foreign investors are willing to settle for are lesser than what we may demand as investors standalone. This forces domestic investors to also settle for the same returns or lead to inflated asset values. Secondly, the return of this money in troubled times rocks our asset markets more than they deserve to on the back of their performance. This is simply the "curse of shallow but attractive asset markets". We will continue to have it till the size of our economy and asset markets grows to a few times its current level (at current growth rate, maybe another 10 years).

What do we watch out for? There is no easy way to make money by second guessing FIIs. A more realistic strategy would be to avoid making losses due to their behavior. That means avoiding entering markets in a euphoria driven by non-domestic factors (US employment data, good results of stress tests in EU etc) and more importantly avoiding booking losses in a fall driven by FII exit due to non-domestic factors. Summary: let the investors be domestic or foreign, make your decisions domestic!

Sunday, September 05, 2010

Book review - When Genius Failed

This book on the LTCM debacle is by no means either new or contemporary. I just happened to dig it out from Landmark one evening and finished reading it today.

LTCM i.e. Long Term Capital Management, was a hedge fund promoted by a clutch of bond traders on Wall Street along with a few academicians (including Scholes and Merton of Black-Scholes-Merton fame). At its peak it had equity capital of more than $ 4 bn and assets of more than $ 100 bn.

The book covers the rise and fall of LTCM in great detail - in a very human rather than analytical way. It is written for lay persons and that shows. A good read for lay persons for sure, but also for the practitioners of modern finance, all the more so in emerging economies like India's. It is not implausible to expect an LTCM like debacle in India within next 5 years. As the complexity of the financial system grows, crises of LTCM variety are more and more likely to occur.

So what exactly happened? LTCM started out as purely a bond arbitrage portfolio with $ 1.5 bn in capital. It borrowed about 25 times that and invested in bonds of various types. It was not a directional bet on the bond prices though. It dealt in what is called convergence trades i.e. narrowing of spreads between two bonds. For whatever reasons if the spreads between two bonds are out of whac with the usual levels, an opportunity to make relatively low risk return arises. One needs to short the costlier bond and long the cheaper one. Over time, as the spreads do narrow, one squares off both the positions and makes a tidy profit. This is market neutral trade since absolute price levels of either of the two positions is not relevant for the profit and loss of the trade. Only the spreads matter.

LTCM did good business in first four years of its operation. However, its success prompted many others to enter the bond arbitrage business. This put the firm in a quandary. It was getting more investors but fewer opportunities. The firm reacted by diversifying into newer areas of convergence trade - including merger arbitrage, volatility spreads and so on. This however was a much more tricky turf than bond arbitrage. Owing to a blind faith in the validity of their lognormal price models and a financial storm precipitated by the Russian bond default of the 1998, LTCM found that the spreads in most of its trades were diverging rather than converging. Owing to its excessive leverage, this proved to be far too much for it to handle. The fund had to be rescued by a consortium of investment banks.

The efficient market hypothesis has turned out to be more a neat modeling tool rather than reliable predictive framework. The book repeatedly refers to fat tails and the ridiculous implicit expectation in normal distribution models that events of 1998 should occur no more than once in the lifetime of the universe! In reality, such events happen once in 25-50 years; and are occuring more frequently in recent decades.

An interesting meta-inference i could draw was as follows. The accuracy of the efficient market hypothesis itself is a market dependent variable. Think of it as the volatility of the volatility. During normal times, the normal distribution (no pun intended) holds much more accurately than during turbulent times. I recall my lessons as an aerospace engineer. In fluid mechanics we always specified whether our models were dealing with laminar flow or turbulent flow (when you open a tap just a little, its water stream is laminar, if you open it fully and the water pressure is good, it becomes turbulent). The models, one would guess, differed significantly. Something similar should apply to the financial world as well. The laminar models are already in place. The turbulent ones need to be developed. (Jump diffusion for option pricing is an interesting start.)

Saturday, September 04, 2010

Index investing and quantitative strategies

I was reading the buttonwood blog in economist - regarding bond indices. A side argument there pointed me to an interesting thought. Index investing has picked up in a big way (at least in terms of mindspace) in the developed economies. It is finding some favor with indians as well. This was no doubt a reaction to the exhorbitant asset management fees charged by managers who ultimately ended up underperforming the index. The thought pioneered by Vanguard and the likes was that lower cost model of index investing is likely to be remunerative in the medium term since no one can sustainably outperform the index anyway.

Leaving aside that reaction, if one were to explore the world of quantitative rules driven investing as against index investing, one reaches the same conclusion sooner or later - index investing is an oversimplified quant strategy! The rules are deceptively simple - in fact so simple that they do not appear to be rules at all! Invest in stocks in the same proportion they form in the index and stick to it. Invest/divest when index constitution changes. Period. A quant model can be extremely complex or relatively simple. The simplest of them can start to look very similar to index investing. And then one realizes that index investing is also a quant strategy - the difference is one of degree and not of nature.

If that be so, can we think of outperforming the index using quantitative strategies? The above-mentioned article in economist spoke of synthetic bond indices which do not over-weight more indebted borrowers unlike the commonly used ones. Thus they end up performing better than the conventional index. Likewise a 'remixed Nifty' ETF launched by one of the new AMCs in India is an attempt to redefine the allocation within Nifty stocks using factors other than market value. Both approaches merit attention. Leaving aside the special status accorded to the index, these discussions are akin to evaluation of two alternate quant strategies. Clearly one with market cap as the sole basis of weightage (i.e. the index) seems less sound than one with some other parameters that incorporate attractiveness of stocks/bonds.

What factors? That remains the holy grail of quantitative strategists! More on that later.