Shadwick’s point is that mathematical finance has developed by trying to emulate the theoretical precision of the hard sciences although it is impossible to do so with events that capture the actions of humans. His view is that mathematical finance has gotten it horribly wrong by answering all the wrong questions. In a lovely quote from Keynes he makes his point:

“We have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine the working of which we do not understand.”

He makes his point early. VaR (Value at Risk) at 99% answers the question “what is the worst loss we should expect in 99 days of 100?” — or, stated in reverse, “what is the least we should expect to lose one day in 100?” He contends this is the wrong question; rather we should ask, “what should we expect to lose in that one day in 100?”

He contends that statisticians know the answer. They call it Expected Shortfall (ES). Further, the calculation of VaR relies on the normal distribution, an assumption that is hopelessly out of sync with financial data. He cited the work of innumerable well-known mathematicians, which show that financial data is far too prone to fat tails to be normal.

ES would suffer from the same problem, except that the technological developments to make it robust occurred before the crash of 1929! It is called Extreme Value Theory (EVT) and -get this – it has been in widespread use in the insurance industry for decades. It has almost been totally ignored by finance.

Shadwick took us through a brief history of mathematics in finance briefly citing the contributions from Bachelier, Fisher and Tippett, Cowles and Gnedenko all prominent mathematicians. When he got to the founder of Modern Portfolio Theory, Harry Markowitz, he made an essential point: Markowitz explicitly brought risk, measured by standard deviation into the discussion for the first time, which inadvertently sent modern finance theory headlong into the two moment world of mean-variance – and it has been paying dearly ever since. Shadwick very appropriately noted that the normality assumption was not made by Markowitz, and indeed, I have heard Markowitz say this on two occasions.

It is this assumption that is the killer in finance theory and it is an underlying factor in VaR, which was globally promulgated by shortsighted regulators at the BIS in Basel I as the metric banks must use to calculate risk.  We now know what folly that was!

Now comes the part missing in Shadwick’s presentation. In his unseen tables (they are available) he shows by employing EVT, the coming collapse was clearly showing up well ahead of its occurrence. His first set of tables analyzes the Dow Jones Index in the months leading up to the 1929 crash. Relying on the probabilities derived from a normal distribution was hopelessly wrong, but EVT was giving the signals well before the main event.

He then shows the ES with Citigroup’s stock. As early as the 27 of February 2007 the first breach showed the ES increasing from 3.93% to 5.92% (daily) and then steadily increasing from then until it went over 60%. The first really big losses in Citigroup’s stock occurred over mid to late September 2008 (!) at over 10% each day, growing to 18%, 23%, 26% and ending with a 39% one day loss.

Shadwick laments’ “we have the technology, why aren’t we using it?”  Indeed.

The first was by a senior adviser to the SEC, Dr. Richard Bookstaber.  Some of you might know him as the author of the excellent, best selling book A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation. Rick comes with a wealth of experience (as did all the speakers). He has worked on both the sell- and buy- side of Wall Street.  He has been an academic, a head of risk management, a head of trading, run a hedge fund and been a quant manager at many of the most prestigious firms in the US. He has consulted to the CPPIB on its risk management culture. So when he speaks, I listen.

Rick made an unusual reference to Gresham’s Law and proposed a corollary.  Gresham’s Law (not really a law) suggests that good money is driven out by bad.  For example, when the Canadian Mint stopped minting silver Quarters because the silver ones had become worth more than 25 cents due to the escalating price of silver and started issuing nickel and copper ones instead, silver quarters quickly disappeared from Canadian change as people started hoarding them.

Rick restated Gresham’s Law to say imprudence drives out prudence. He was referring to the paradox that while everyone on Wall Street knew that synthetic CDOs for example, were destined to implode; no one could refuse to deal in them because there were always some investment banks that would. Therefore, not to deal meant passing up significant profits and thereby giving competitors an economic advantage.

Bookstaber’s Law as I shall name this insight, gives us a means to judge the new regulation that is being proposed in the US Congress. The Obama administration is crowing that this is the most significant overhaul of Wall Street since the 1930s. I am not so sure.

Take the Volker Rule which I wrote about in an earlier blog entitled “Hedge Fund Managers High Five Obama”. The rules proposed by Volker were emasculated by the Senate negotiators. As well, regulators have been effectively removed from writing the language of the Bill, thereby leaving it up to conflicted politicians.

Clearly the powerful investment banks have been spending huge lobbying dollars to kill any effective regulation. The same phenomenon is occurring in Europe. The banks are calling the tune.

Bookstaber’s Law is in effect.  Everyone knows it’s destined to fail, but no one is willing to potentially lose an advantage. Therefore they will continue to play the imprudent game.

As a sidebar, the one part of the reform package that does look meaningful is the establishment of the Financial Stability Oversight Council, a super-regulator that will monitor Wall Street’s largest firms and other market participants to spot and respond to emerging systemic risks. The Treasury Department will lead the panel, which includes regulators from other agencies. In his remarks at the Niagara Dialogue, Bookstaber seemed to favour this council perhaps because it gave the power to the Fed and other more independent agencies.

With a two-thirds vote, the council can impose higher capital requirements on lenders or place broker-dealers and hedge funds under the authority of the Fed. The council also will have authority to force companies to divest holdings if their structure poses a “grave threat” to U.S. financial stability.

It remains to be seen what actually becomes law with this Bill and how much meaningful reform is actually achieved. But I thought Bookstaber’s insight was a wonderful nugget to take away from this symposium.

More to come…

Last week I had the privilege of attending an excellent hedge fund breakfast discussion hosted by CIBC Mellon at the National Club. Moderated by none other than our highly literate editor, Dr. Caroline Cakebread, the exceptional panel spoke to a sellout house.  What made the panel and the session exceptional was the highly knowledgeable and experienced speaker roster, all of whom were refreshingly articulate. Gary Ostoich, Spartan Funds Managment; Chris Addy, Castle Hall Alternatives, and Peter Hayes, KPMG did a superb job.

Only one question, including those from the floor, did not get the treatment I expected: “Is there still such a thing as hedge fund alpha?” It is an interesting one indeed.

To be fair to the panelists, the question was not well defined so they had different directions they could go in. Focusing on the modifier “still”, one could interpret the question to mean that there have been a lot of hedge fund replicants appearing in the last few years who claim to be able to create the properties of hedge funds without actually owning one. They do this in one of three ways: 1) replication of the return distribution and its properties; 2) creating passive exposures with various statistical factors which capture hedge fund properties; or 3) passively mimicking hedge fund trading strategies.

What is appealing about these replicants is that they are cheaper, liquid, transparent, and mechanical — but are they alpha? Decidedly not! However, the point is that a lot of so-called hedge fund alpha is actually beta and exotic beta. So, of course this begs the essential question–what is alpha?

I like to think of alpha as the dark matter of investing. Physicists and astronomers who try to calculate the matter/energy inventory of the universe add up what they know and subtract that from the total and the residual which is very large, they call dark matter. Similarly, financial mathematicians add up what they know (return to betas), subtract it from the observed return and what is left over is called alpha.

Unfortunately, this is a haphazard process because not all the beta variables get included.  In fact, usually the S&P500 beta is the only one included. This artificially enlarges alpha. As implied earlier, the more betas that are included, the return assigned to alpha will decline. Hence the moderator’s question.

However, there is another interpretation of this question. With the turmoil in the markets of 2008 and 2009, hedge fund alpha either disappeared or became negative. So are we seeing the return of alpha?

Like all questions on this subject, there are many subtleties, so I ask forgiveness from my readers for not delving into them in this short blog post. My answer is, yes, absolutely, it is back and it will come back in spades. Volatility creates opportunity to earn alpha. The general removal of bans on short selling (except the Germans), reduced assets chasing the same trades allows a greater share of the alpha pie among those remaining and the Volker Rule, which looks like it may be implemented, will remove bank prop desks from the alpha hunt. All of these factors make me optimistic that we are in a sunny period for alpha generation among hedge funds.

We have known for some time that the ability to earn alpha ebbs and flows. This is evident in many of the studies that academics undertake. What we all must keep in mind however is the alpha distribution (before fees and transaction costs), which has a zero mean. Therefore for every alpha winner, there is a loser meaning that if hedge funds are going to be like the above-average denizens of Woebegone Lake, they must as a group be taking if from some other group. Who do you think that might be?

Subsequent to his remarks, I am sure that he was appalled at Germany’s irritating unilateral moves of banning short positions in financial stocks (naked or not) and naked positions in CDSs on sovereign bonds and large German banks.  The Germans just do not seem to get it.  Predictably rather than reducing volatility, the measure enhanced it just as their actions did in 2009. And it is these short-sighted and largely uninformed regulators who are leading the charge on taxing financial transactions rather than simply raising bank reserve requirements.

Richard Werner waded in with a controversial message.  He reminded us that it is not central banks that create capital but the banking system itself. As such, a very simple solution to the serial bank-created bubbles is to limit the means whereby commercial banks create capital. Rather than let banks lend however they wish, controls should be placed on the credit creation process with respect to financial transactions. In a way this is similar to Volker’s proposal of banning banks from engaging in proprietary trading and other risky activities, which are at the heart of what Werner is talking about.

It became controversial when Werner accused the ECB of not wanting to control bank capital because they indeed wished to precipitate crises to meet their longer term objective of a centralized fiscal agency. Further, it has purposefully created every crisis to date!  Its goal is to create the United States of Europe. Professor Wade, while supporting further integration of Europe economically, did not see events heretofore as the product of a conspiracy.

Professor Stiglitz was mindful of these themes and added further colour to them. But his view is that Europe will muddle through again and patch the system through compromise as it always has. He sees no hope for the southern European nations other than default, but they are a sidebar to the main action. In fact the UK, Japan and the US are in worse fiscal shape than any of these countries and this is the problem. Further, countries which create large trade surpluses without letting their currencies adjust are creating deadly imbalances in the global economic order.

Clearly all the speakers were very concerned about the events unfolding in Europe but none could clearly articulate a solution or even see a way out of it that was politically feasible.

Following Lord Patten’s lead-in, Jacques Attali made many interesting observations. As he was one of the original architects of the EU, his commentary carries a lot of weight. He noted that, at the conception point of the EU, the architects knew they could not create what was ultimately needed because it was politically unacceptable.  Instead the leading member countries, namely Germany and France, have used periodic crises to advance the European Union to its ultimate state.

The current crisis is an opportunity to do that. The final state would be a central government with the autonomous fiscal power of taxation and spending–a condition that a later speaker, Nobel Laureate, Joseph Stiglitz, indicated was the final piece to make Europe an optimum currency area as defined by Canadian economics Nobel Laureate, Robert Mundell. The political rub is whether the member states could give up their autonomy to the greater good?

Attali was suggesting that this crisis was another opportunity to advance the cause, though he declined to say whether it would be successful. Sounding a hopeful note, he remarked the EU is now so entwined that path of least resistance is to integrate further. Germany he pointed out is well along the way of accepting this idea.

Agreeing with Patten’s comments, Attali said that OECD member countries can no longer rely on debt driven economies to grow. Patten asked Attali if Europe was likely to try to inflate their way out of the mess. In response he made this very noteworthy point–“yes that has been a solution governments have successfully used in the past, but today the problem is actually creating inflation! Furthermore the demographics of Europe with its ever increasing elderly population is dead against inflation.

More to come….

The focus of this conference is on Europe and the EU’s ability to survive.  Once again the organizer who plans topics, sessions and speakers 6 months ahead has been prescient. Talk about topical!

But the setting is a bit surreal-London is bustling with visitors, even with the flight interruption from the unpronounceable Icelandic volcano closing airports.  The streets are filled, expensive cars are everywhere, theatre tickets are in scarce supply, and restaurants are chock-a-block filled every evening of the week. Do any of these revelers read the papers?

The Pound and Euro are collapsing, new financial regulations are being proposed, sovereign rescue packages are being announced, CDS spreads are blowing out and in general, the economic news coming out of Euroland is scary indeed.

As we sat in the comfort of the Landmark Hotel, Canada received much airplay at this conference, even though the number of Canadians attending could be counted on one hand.

The opening session featured former British Tory Prime Minister, Sir John Major, interviewing former Canadian Finance Minister and Prime Minister, the Right Hon. Paul Martin, on how he took Canada from being a Third World state, as declared by the Wall Street Journal, with a budgetary deficit of $42 billion to running surpluses in a few short years.  Were there lessons the UK and EU member countries could take from this?

Mr. Martin was indeed engaging and he owned up right out of the gate that he had help from the GST which the Conservatives had recently implemented in their tenure as Government. Listeners were complimentary and asked lots of questions.  While there are a lot of differences between Canada’s situation and Europe’s, the main point was that it can be done.

Hard on the heels of this excellent introduction to the conference was Lord Patten of Barnes  (the last British appointed Governor of Hong Kong, among many, many other things) and Jacques Attali, Chairman, President Sarkozy’s Economic Reform Commission (among many, many other things) discussing the future of Europe.

Check the next installment of this blog for a synopsis of the very insightful observations these two highly experienced men made.

Faith and financial dealings have an essential common element in trust.  Without it, neither can exist.  Goldman Sachs, it is alleged, made the egregious error of favouring one client over another without proper disclosure and in the process earned substantial fees. GS has been on the receiving end of a significant amount of public scrutiny of late-the lingering impression that senior executives have a direct pipeline to the White House, the accusations that they helped Greece obfuscate its massive debt problems from the EU using swaps, and now, assisting John Paulson, a hedge fund manager, make billions shorting subprime mortgages at the expense of its own clients.

The problem centers on the fact that they did not declare their conflict of interest to the clients who were the buyers of the toxic paper that Paulson’s hedge funds were selling. In particular what was not disclosed was the fact that Paulson selected the RMBSs (residential mortgage backed securities) that the ABACUS Trust was effectively shorting and instead implied it was an independent portfolio selection agent.  Potential investors were far less likely to be the counterparty to these transactions, at least at the offered price, if they knew Paulson was on the other side.

Financial prestidigitations such as these are legend on Wall Street as it seems it is an accepted fact that if you wish to condition your balance sheet for a public reporting, any manner of derivative can be created to favourably manipulate critical values during the reporting period.  One of the major issues with Lehman Bros was the fact that it had blurred its weak financial condition from the public until it was too late.

This promises to be a major donnybrook, with the SEC still nursing open wounds from its gross mishandling of the Madoff affair squaring off with the most prestigious of all American financial institutions.  There is a huge amount at stake for both as the SEC attempts to regain the public perception that it is a regulator with teeth and as Goldman Sachs strives to regain its reputation and trust with its clients.  The bell for round two has rung.

In a classic twist of Virgil’s Aeneid, Warren Buffet says it all.  I have just finished reading the highly readable and engaging book by Wall Street Journal writer Scott Patterson entitled The Quants. I am reminded of a similar excellent work written by Richard Bookstaber entitled A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation.

These two books are hugely instructive and really should be read as a pair.  Bookstaber, who holds a doctorate in Economics from MIT, lived the dream on Wall Street in the first heady days when computers and quantitative methods were just cutting their teeth.  He was a participant in the events leading up to the 1987 market collapse.  His specialty was risk management and he chronicles its failure and how it managed to create the massive market vortex in late October 1987 through a process called ironically, portfolio insurance.

Patterson has a different perspective as a journalist, not being so embedded in the process but rather as an observer who has managed to string together a rather frightening tale through interviews and anecdotal evidence.  He has most of the major Wall Street players covered in the second heady days when computers and quantitative methods had completely taken over.  His book lets you in on the personalities of the major quant players-Cliff Asness, Ken Griffin, Boaz Weinstein and Peter Muller to trace the impact of huge sums of money being run by computer-operated, highly leveraged hedge funds and prop desks through complex formulas dreamed up by these mathematics wunderkinds.  Goldman Sachs, Morgan Stanley, Bear Stearns, Lehman Bros., AQR and Citadel are regularly featured in the compelling narrative.

Patterson picks up where Bookstaber leaves off at LTCM in 1998.  The real action begins with the massive Quant Unwind that began late in July 2007 and crescendoed in August. I recall having to comment on this event at a Roger’s Media Risk Management Conference in August 2007, and frankly I am stunned at how close to the money my explanation was. At the time massive confusion existed in the market and it has only been the passage of time that has let observers like Patterson chronicle the events.

There are many lessons evident in both of these books.  The latest market crisis cannot be blamed on Quants-they and their processes were one of the enablers of the collapse just as Alan Greenspan was (no matter how much he protests to the contrary!).  Both these books should be required reading by all who labour in our industry in order to make them understand the overarching roles of luck and hubris in the financial dealings of man…

Let’s look at it this way. If you were invested in a managed account during 2008 and early 2009 when markets went into extreme turmoil, your demand for liquidity was met in a timely fashion saving you a lot of money.  Furthermore, it was unlikely that your assets became embroiled in Madoffian-like fraud, that they were exposed to Bear Stearns or Lehman liquidity/bankruptcy issues and you sidestepped toxic paper-induced valuation issues.  Being free of these costly events certainly seems to me a price any investor would be more than happy to pay.

One of the greatest values to investors of managed accounts seldom gets any airplay at all.  Investors who utilize a regime of managed accounts offering weekly or monthly liquidity representing many different hedge fund styles are given a whole new alpha generation tool. They can effectively manage the beta of their hedge fund bets by up weighting and down weighting different styles in their portfolio as economic conditions change.  Take 2008 for example.  This was the year to have a large exposure to CTAs and low or no exposure to convertible arbitrage.  The exact opposite was the case in 2009.

Some nimble managed account providers very effectively used this tool in their funds of funds to add a lot of value for their investors.  Traditional funds of funds were down an average of 20% in 2008.  Funds of funds offered by managed account providers had a decidedly more sanguine experience with many reporting returns of -5% or better.

So going back to my original premise, when one reads surveys on prickly issues like managed accounts, you always have to be aware of the people who are answering the questions and the biases they harbour.

But we are not the only people who are enamoured of gold lately.  It seems that some very important hedge fund managers have discovered the shiny metal.  It is well known that the first into the golden pond was our own Eric Sprott, who was well ahead of the crowd when he bought most (some say all) of the bullion the Bank of Canada sold several years ago. It now slumbers deep below the streets of Toronto in the safety of the ScotiaBank vaults.

After several months of poopoo-ing gold, George Soros suddenly became its greatest fan-presumably after his buying program was completed. And before him, another hugely successful and mega rich hedge fund manager, John Paulson started a fund to invest solely in gold and gold-related securities.  Now I have a very high regard for both of these managers and in my experience, neither lays a lot of money on the line without having a high probability of a win and furthermore, a low probability of losing money. (Not the inverse of one another.)

What property of gold gives it this unusual payoff pattern?

For over a year now economic forecasters have been evenly split between seeing a post crisis world of raging inflation and depressing deflation.  The inflation camp points at the high monetary creation and fiscal stimulus as the seed for future price increases.  The deflation camp points to the massive output gap, high unemployment and huge central bank balance sheet distortions as the source for deflation.  Frankly, who knows?

Gold responds positively to both of these events because of its inherent store of value characteristic.  If assets are devaluing, gold is the ultimate store of value.  Consequently, the only scenario where gold investors lose is if we slowly return to a normal functioning economy. They are winners in the deflation and inflation scenarios.

And the wild card in how this plays out is China.