PIMCO - Portable Alpha Theory and Practice Epilogue Dialynas

In the movie The Rocking Horse Winner, adapted from a D.H. Lawrence short story, a boy was haunted by a chant from his house, “There must be more money!” in reference to his mother’s constant need for more money to make extravagant ends meet. The dedicated child, who adored his mother, responded to the chant by partnering with the gardener, who regularly bet on horses. The boy would rock on his rocking horse faster and faster until he determined the winning horse upon which he could place his bet and satisfy the needs of the house. In the end, the heavy demands of the house were so great and the difﬁculty of choosing the winner so onerous that the boy died after picking a big winner. The mother, ignorant of and unsupportive of the boy’s activities, refused the big payoff, saying, “I’ll have nothing to do with blood money.” In the movie, the boy had to do more and more to keep up with the “wants” of the house. So, too, are the demands on absolute return managers, and the greater required energy is manifested in greater leverage. Ultimately, death of the strategies occurs for the house (the investor loses money) and the blood money is in the hands of the investment manager. In this ﬁnal chapter we will learn how and why this is happening and why we believe it is a very relevant epilogue to Portable Alpha Theory and Practice.

The investment landscape is much different today than at any time in the past. Investor dreams of double-digit returns have provoked leveraged investment schemes—often-referred to as alpha engines—of dubious quality.

Structured products, hedge funds, private equity funds, and other so-called absolute return investment strategies are all increasingly important market participants. The capital deployed in these products by investors is enormous and has been growing at a very fast rate. By way of example, the hedge fund industry has grown from essentially nothing in 1990 to about $1.5 trillion in 2006 and is rapidly approaching $2 trillion, as noted in Chapter 6 and depicted in Figure E.1.

These investment strategies commonly employ derivatives and abundant leverage to generate “excess” returns. In contrast, in my early days at PIMCO in the 1980s, we utilized the inherent ready-made leverage of ﬁnancial futures and the to be announced (TBA) mortgage market in an unleveraged manner to produce alpha. The concept was simple and elegant—arbitrage the low implied cost of ﬁnancing imbedded within the futures contract and the higher prevailing high-quality market rates of interest for short-term bonds, a strategy we referred to as “BondsPLUS.” At that time, ﬁnancial futures were the only derivatives available, and high-quality, unleveraged investment standards were rigid. An additional landscape change is the growth of the cumulative U.S. current account deﬁcit, representative of investment funds in foreign investors’ hands, from nothing in 1984 to over $6 trillion today. The combination of leveraged investment schemes and foreign investors is a potentially lethal one. As a result, the new leveraged ﬁnancial market architecture and system have profound implications for both investment strategies and public policy.

The rapid growth of the credit derivatives market to approximately $25 trillion as shown in Figure E.2 reﬂects the demand for ready-made LIBOR ﬁnancing and leverage.

The transformation of alpha engines from high-quality ﬁnancing arbitrage to leveraged beta strategies, called alpha, stands in sharp contrast to the prevalent conservative attitude of the 1980s. The structured products market is a good example of statistical engineering, whereby leverage is used as a tool to create products with return promises too good to believe. Structured corporate bond products provide leveraged exposure to the corporate market and beneﬁt from book value accounting. Structured product is engineered and dependent on statistical default and correlation data. The engineering of cash ﬂows transforms well-diversiﬁed leveraged portfolios of corporate bonds, primarily BBB rated, into assets rated AAA, AA, and A. Growth in this market is shown in Figure E.3.

Unfortunately, few investors seem to understand that statistics are environment dependent. The structures resemble Pascal’s wager in that if the statistics are unreliable, the value of the structured product can drop rapidly as the short convexity cliff is hit. The radically changed ﬁnancial markets, inﬂuenced by increased globalization and characterized by high leverage in the United States, exchange rates pegged cheap to the U.S. dollar, and enormous technological advances, suggest that it is highly likely that the statistical conclusions are unreliable.

The investor in leveraged hedge fund or other absolute return strategies, the leveraged structured product investor, and the foreign investor all represent sources of demand that drove down risk premiums and market volatility in the period from 2003 to 2006. The lower risk premium and lower volatility premiums mean that an even greater amount of leverage is required to achieve a stipulated nominal return objective. The leveraged absolute return schemes are viable as long as funding is plentiful. However, if funding is withheld, the highly leveraged strategies can unwind quickly. This dynamic is akin to the portfolio insurance strategies of the mid-1980s. The increase in leverage bids up the value of assets, compressing risk spreads and simultaneously increasing the fundamental risks associated with those assets. It is incorrect to assume that compressed spreads and low volatility imply low risk. Quite the contrary.

Risk Asymmetries: Volatility, Spread, Leverage
Another challenge relates to the compensation schemes afforded to hedge fund managers that may actually inhibit, rather than encourage, rational decision making that is in the best interest of the investor. The typical 20 percent participation in excess returns is a call option. Increasing the risk of the fund maximizes the call option’s value. Consequently, the fund manager will rarely return assets to investors or hold the assets in cash when valuations are poor relative to risk. Negative carry trades require good timing or strong conviction. It is rare for a hedge fund manager to engage in such a trade, because the call option on fees is worthless if an event does not occur. If the hedge fund manager is engaged in a carry trade when the downside of the associated risk emerges (the bad event happens), the client loses a lot of money but the hedge fund manager merely loses business. Perhaps a clever hedge fund manager should divide his business into two portions, positive carry and negative carry, and thus always be assured of great fees. (See Chapter 3 for greater elaboration about manager fees and market asymmetries.)

We have already established the linkage between high leverage, low volatility, and low risk premiums. These dynamics invalidate traditional investment assumptions of normally distributed returns and create signiﬁcant risk/reward asymmetries. Investors should disinvest or short leveraged asset markets offering little premium and minimum volatility. Leveraged carry strategies in these markets are extremely dangerous as they are ripe for a violent mispricing. Investors should sacriﬁce yield in these situations, because the maximum opportunity is the sum of the yield spread plus the product of the yield spread times the bond’s duration, whereas the gain from a short position is potentially large because an increase in volatility and spread is positively correlated and negatively related to leverage. Perversely, a reduction in leverage in the macro system increases volatility and increases spreads.

The simplest example of a risk/return asymmetry is a corporate bond. An investment in a corporate bond provides investors with the product of the initial yield advantage times the term of the bond in the best case and possibly negative 100 percent in an extremely negative case. Minimal risk premiums imply minimal yield advantage. An example will illustrate the point. Assume an investor has a 1-year investment horizon and is considering an investment in a 10-year Baa corporate bond with a duration of 6.5 years and a yield that is 75 basis points greater than the yield on a 10-year Treasury note (i.e., a yield spread of 75 basis points). We can see the very poor risk/return proﬁle in Table E.1. Because of the asymmetry shown in the table, Schumpeter believed the bond investor was the hero of capitalism (the risk taker), not the entrepreneur.

Returns are expressed in percentage terms.
*It is a highly improbable event that the yield spread would decline to zero, as this would mean that investors do not demand any compensation for the credit risk that they are assuming. Nonetheless, the price gain associated with the elimination of the yield spread plus the initial yield represents the maximum possible return to an investor who holds a long position in a corporate bond. Conversely, as noted earlier and shown in Table E.1, the downside to the same investor is theoretically infinite, as there is no limit to the possible increase in the yield spread.

Figure E.4 depicts the distribution of spreads on 10-year Baa corporate notes from 1980 to 2007. As shown in the chart, when spreads are already at very low levels, the asymmetry between the reward of further yield spread declines and the risk of (possibly material) increases in yield spreads is strikingly apparent.

Of course, if leverage is involved, even a relatively modest change in yield spreads can lead to devastating losses, as demonstrated in the following leveraged carry trade example. We now know the structured subprime mortgage asset-backed market valuations in 2006 were exemplary of this risk proﬁle.

Absolute Return Dynamics
Hedge fund returns tend toward subpar during periods of heightened market volatility. Higher volatility results in higher bid-ask spreads, more costly money (borrowing), and margin calls, leading to the unwinding of positions. Highly leveraged strategies geared to high absolute returns are strategies that can be characterized as the sale of options at the tail of the assumed distribution.

We can think of a dynamic game where there is only one participant. This participant can set the leverage such that the strike price of the option sale is where he pleases and receive a market volatility premium. Under normal conditions, the participant can fare well because the game is fair. A nominal return distribution approximates reality. However, the high leverage is incompatible with high volatility, particularly in a VAR framework. In fact, a review of historical data indicated that the performance of hedge funds examined deteriorated very rapidly during periods of heightened volatility once the strike price approached. This relationship is exhibited in Figure E.5 by the inverse correlation between hedge fund returns, on average and across most style categories, and the VIX as a proxy for market volatility. (The VIX is a volatility index created by the CBOE to measure equity market volatility.)

We found the same relationship when examining individual hedge fund strategies. In the case of the individual funds analyzed, they were hand selected by an institutional investor with the goal of diversifying risk across different managers and strategies, yet all exhibited a negative correlation with volatility. Therefore, on average, when volatility increased the performance for all of the funds declined. As a result, during periods characterized by sharp increases in volatility the investor may ﬁnd the theoretical diversiﬁcation beneﬁts provided by the group of hedge fund strategies to be sorely disappointing.

This is consistent with the idea that performance is very negatively convex at the strike price, resembling a cliff, as illustrated in Figure E.6.

The increased systemic leverage and foreign participation negate normally distributed return assumptions. The correct distribution is impossible to specify, and, if speciﬁed, the equation is very difﬁcult, if not impossible, to solve.

The dynamics become more interesting when we introduce many more participants who hold similar investment objectives. The competitive desire for a given return objective leads to three possibilities: (1) more leverage, (2) a strike price closer to the spot price, or (3) a combination of (1) and (2). The greater leverage provides for more of a given spread, and striking the option closer to the money yields more premium. As more and more investors enter the game, each must get in front of the others to retain competitive status. Fund managers get in front by engaging in one of the three possibilities, which lead to similar increases in risk/reward and hold similar implications for public policy. Moreover, the compensation structure of the hedge fund industry provides incentives consistent with the postulated behavior, which is inconsistent with a rational investor’s utility function.

The dynamics become even more interesting when we introduce large players who hold political objectives: foreign investors. A large foreign investor can inﬂuence yield premiums, particularly if the stock of assets held is large and the inﬂow also is large. This investor can induce volatility if he abruptly alters his investment strategy, impacting the pricing of risk in a material way. The range of corporate bond spreads shown in Figure E.4 highlights the potential for variation in Baa (investment grade) credit risk premiums as an example. The abrupt change in strategy results in increased volatility, which then causes the hedge fund investors to experience the downside of the negatively convex cliff illustrated in Figure E.6.

The U.S. Current Account Deficit, War, and Hedge Funds: Briefly
The U.S. war on terror began in 2001 and continues today. Countries at war prefer: (1) well-functioning capital markets, (2) open trade, (3) minimal market volatility, (4) low risk premiums, and (5) rising markets. These conditions lead to low ﬁnancing costs and efﬁcient production. Historically, market price deterioration results from losing a campaign or diminishing public support for the war initiative. It is at this point that government controls over trade and ﬁnance substitute, in the name of patriotism, for open trade and ﬁnance. Markets tend to perform very poorly when this occurs—assuming they remain open.

Leveraged strategies directed to higher-yielding assets reduce risk premiums and suppress volatility. An overvalued U.S. dollar and the consequent large current account deﬁcit support dis-saving in the United States and provide funds to foreigners to reinvest in the U.S. markets, further suppressing risk spreads and volatility and raising U.S. asset prices. (The impact on dis-saving in recent years is clearly evidenced in Figure E.7.) A risk management approach to policy at the Federal Reserve further reinforces the market behavior. U.S. consumers and investors alike feel great because foreigners ﬁnance U.S. consumption, and asset appreciation creates wealth.

The war effort is advanced by an economy operating efﬁciently with low volatility/low risk premiums. The price appreciation of the U.S. housing market for 2002 through 2006 is a result of this policy attitude. Moreover, the U.S. government has an organized market surveillance committee to ensure market stability and, presumably, the consequent economic efﬁciency. Distortions in capital allocation that result are largely ignored. Unsurprisingly, hedge fund leveraged strategies, the large trade imbalance, and U.S. war efforts serve to reinforce each other. The importance of the accumulated misallocations of capital will be realized very dramatically when a meaningful change in the war campaign occurs. Investors are wise to avoid leveraged absolute return strategies when that day arrives.

Public Policy Implications
The present ﬁnancial schemes that incorporate highly leveraged strategies concurrent with a horribly imbalanced global economy are very binding on public policy. The greater and greater leverage and closer and closer cliff strike prices imply that the range of tolerable market movement and volatility increases is becoming a smaller and smaller segment. This suggests that policy makers must respond to market volatility more quickly, as depicted by the narrower public policy discretion interval in Figure E.8, or risk a major credit contraction as leveraged strategies delever and disintegrate.

Increases in leverage and credit are very beneﬁcial to an economy until, as Schumpeter posited, credit contraction produces deﬂationary results, and, as Miller-Modigliani showed, the increases in leverage disproportionately increase bankruptcy risk. So, too, with the general economy.

Conclusion
Ironically, what began in the early 1980s as a simple ﬁnance arbitrage PIMCO portable alpha strategy has evolved in some cases to highly levered, unregulated portable alpha hedge fund strategies. Both are referred to as the alpha source in a portable alpha context, but they are vastly different in terms of the potential downside risk. Coincident with a globalized ﬁnancial system completely out of balance wherein “Renegade Economics”¹ rules the public policy front, disintegration of many of these highly levered schemes is not the question. The questions are when and how bad. The leveraged schemes were created to fulﬁll investor dreams. The schemes perpetuated the increase in global liquidity, global imbalances, ﬁnancial risk, and geopolitical risk. A sharp reversal in liquidity that could result from a necessary risk reassessment may be difﬁcult to contain. The reversal in liquidity will most likely derive from an abrupt foreign reallocation away from U.S. assets, as losses on prior investments of presumed high quality are realized, marking the secular peak in global trade. Moreover, the newly created so-called sovereign wealth funds will eventually be viewed as imperialistic vehicles further exacerbating global political tensions and will therefore increase market risk.

Financial engineers quantify the risk inherent in a strategy in very precise statistical and Greek terms. The credentials of the engineers and complexity of the models further authenticate the output. The application of math, physics, and statistics to ﬁnancial assets has provided a security blanket to investors. The quants prove things. However, economics and investing have never been precise sciences. Highly leveraged investment schemes appear stable. No doubt there is a wide range of quality among the many absolute return schemes, as well as a wide range of hidden embedded risk. The embedded risk is hidden in the model derivation and the assumptions therein. Understanding the embedded risks, assumptions, and changing risk character of the various types of portable alpha strategies, as embedded options are attached and alpha morphs into beta, is the main point of this book. To truly accomplish this for portable alpha approaches and other investment schemes more broadly, politicians, policy makers, and investors alike must recognize that double-digit investment returns in a low single-digit interest rate world are inconsistent, likely of very high risk, unsustainable, destabilizing, and subject to severe loss potential.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from Portable Alpha Theory and Practice: What Investors Really Need to Know. Copyright © 2008 by Pacific Investment Management Company, LLC. This book is available at all bookstores, online booksellers and from the Wiley web site at www.wiley.com, or call 1-800-225-5945.

^¹As described in “Renegade Economics: The Bretton Woods II Fiction” by Chris Dialynas and Marshall Auerback (September 2007, www. pimco.com).