Your Risk Analysis Sucks

Yesterday I was discussing some risk analysis with a colleague. Specifically, quantitative risk scores for fixed income funds. The details of the scoring are not important for the purposes of this post. Suffice it to say it is along the lines of sorting funds into quartiles based on statistics such as rolling volatility and drawdown.

The point of our discussion was that soon the financial crisis period will roll off the risk scores, penalizing more conservative portfolios in the ranking system. The scores will implicitly reward excessive risk-taking.

This is a great metaphor for the state of markets today.

Collectively, we have forgotten what it means to be afraid. Today, it is all about squeezing as much return as possible out of a portfolio. Fear has rolled off our collective memory. And what’s worse our lack of fear is justifiable according to the trailing 10-year data.

This at a time when:

  • Credit spreads are tight.
  • Covenants are weak.
  • Leverage is high.
  • Oh, and interest rates are rising.

There is an inherent tension in risk management between simple statistical measures (which people prefer) and the true nature of risk (which is nuanced and difficult to quantify). In fixed income in particular, the payoffs are negatively skewed. As an extreme example: “I have a 94% chance of earning a 6% yield on my $100 principal investment and a 6% chance of losing the $100 of principal.” Only in real life we don’t know the probability of default in advance.

The standard deviation of a high yield bond fund does not do a great job of describing its risk. In the absence of defaults the volatility will be fairly mild. If defaults tick up in a recession, losses could be catastrophic–particularly if liquidity dries up and twitchy investors decide to redeem en masse. None of the most significant risks to a high yield investment are properly captured by its standard deviation.

But people do not want to talk about conditional probability and expected losses given default and the uncomfortable fact that their financial lives are non-ergodic.

People want simple, black and white answers.

Statistical risk analysis is popular because it uses straightforward inputs and is easy to run at scale. Looking at a portfolio and puzzling out how it might behave in future states of the world, without relying on correlation and volatility statistics, takes a lot of time and energy. It is a “squishy” process. Your peers might think you are a bit of a crank because you aren’t sufficiently “data-driven.”

Oh, and much of the time things will run smoothly anyway.

Diligent risk management is a thankless task. No one pats you on the back for the things that didn’t go wrong. In fact, in a market environment like this one, a little extra prudence can get you fired.

This is why cycles happen. People forget that a little fear is healthy. Or, more precisely, the market environment conditions people to invest more aggressively. They overreach (their backward-looking risk analyses encourage it!) Then when the cycle rolls over they get slaughtered.

Whenever I am looking at an investment one of the things I think long and hard about is under what conditions it might explode spectacularly like a dying star. Excluding fraud, these kinds of blowups are generally caused by leverage (too much debt or financial derivatives with embedded leverage a.k.a convexity) and asset/liability mismatches.

It should be fairly straightforward for a competent analyst to identify and control these risks. More importantly, as analysts we should be getting these things right more often than not as they are triggers for catastrophically bad outcomes. What’s more, none of them is captured by backward-looking statistical measures.

The Alchemy of Risk

Here is a recurring theme from this blog: “risk can never be destroyed, it can only be transformed and laid off on someone else.”

Or, in the words of the late, great Marty Whitman: “someone has to pay for lunch, and I don’t want it to be me.”

Often people think they’ve destroyed risk when they buy a financial product with a guarantee attached. In finance, “guarantee” is just a fancy word for “promise.” When you buy a financial product with a guarantee attached, you’re swapping market risk for something else. Usually it’s a stream of payments with its own set of risks.

The person selling you the stream of payments will tell you that you’ve gotten rid of your risk. And you have, to an extent. You’ve gotten rid of A risk. You’ve traded your market risk for credit risk (your counterparty might not make good on their promise) and purchasing power risk (your stream of payments might not keep up with inflation).

Some of you will say, “but the counterparty is contractually obligated to keep is promise!”

To which I say, “so are bond issuers and individual borrowers. Yet they default all the time. Sometimes they even commit fraud.”

Others will say, “you don’t know what you’re talking about! The government has insurance funds for deposits and pensions!”

To which I say, “promises, promises, all the way down.”

How does the government fund its promises? With tax revenue, partly. But more importantly, with debt. Like I said–promises, all the way down. Dollar bills are themselves promises. What is the “full faith and credit of the United States government” but an elaborate series of promises?

Anyway, for normal people the most common example of “risk transformation” would be buying an annuity or whole life policy from an insurance company. But there are more exotic examples.

Banks like to sell structured notes to their wealth management clients. These are difficult products for the average person to understand. They usually promise a return based on the price performance of some index, subject to certain limitations. For example there will be a guaranteed minimum return and a cap on the high end.

(Notice that I said price performance. If you buy a structured note, no dividends for you!)

Banks like this opacity because the complexity makes it easy for them to bake profits into the structures, which are literally designed by mathematicians (actuaries). The products are sold based on the guaranteed minimum return, and the chance of modest upside. As the buyer, you overpay for the downside protection (the guarantee). When you buy a structured note, you are basically lending the bank money so it can write options and eke out some trading profits. In return you get a more bond-like risk profile.

Meanwhile, you are an unsecured creditor of the bank. If the bank goes bust, your investment is toast. So much for guarantees. Get in line with the rest of the unsecured lenders. Ask the people who bought structured notes from Lehman Brothers how it worked out for them.

In general, the more complicated the product, the worse a deal you are getting. Of course, there can be good reasons to swap market risk for a guaranteed stream of payments. Just because you overpay for downside protection doesn’t make you a sucker.

But lunch is definitely on you.

“To the moon!”

From The McKinsey Global Private Markets Review 2018 (subtitle: “The rise and rise of private markets”):

McKinsey_PE_Rocket_Ship
Source: McKinsey

Your eyes do not deceive you. That is literally a rocket ship with stabilizer fins made of dollar bills, blasting off into the stratosphere. I like to imagine it’s headed off to join the crypto people and their lambos on the moon.

A few highlights from the introduction:

“Private asset managers raised a record sum of nearly $750 billion globally, extending the cycle that began eight years ago.”

“Within this tide of capital, one trend stands out: the surge of megafunds (of more than $5 billion), especially in the United States, and particularly in buyouts.”

“What was interesting in 2017, however, was how an already powerful trend accelerated, with raises for all buyout megafunds up over 90 percent year on year.”

“Investors’ motives for allocating to private markets remain the same, more or less: the potential for alpha, and for consistency at scale.”

This is what you see when an asset class gets frothy. And private equity is an asset class I have had my eye on for a while now. As I have written before, and as McKinsey says somewhat obliquely in their report, institutional investors have come to view private equity as a magical asset class.

We have seen this movie before. It happened with hedge funds in the early 2000s (spoiler alert: it ends with capital flooding into the space and diminished future returns). There are no magical assets. People ought to know better by now. I guess the allure is too powerful. Particularly for return-starved pension systems.

Anyway, when this thing turns there are going to be knock-on effects in a couple of other areas: namely high yield debt and leveraged loans. The gears of the private equity machine are greased with high yield debt. These days there is a strong bid for crappy paper. Especially crappy paper with floating rates.

The yield on the S&P/LSTA US Leveraged Loan 100 Index is something like 5%. Meanwhile, 2-year Treasuries yield 2.5%. And loan covenants suck, which means when defaults inevitably tick up recoveries are going to suck. Buyers are so fixated on interest rate risk they’re overlooking the credit component. You can keep your 250 bps of spread, thanks. Doesn’t seem like a great risk/reward proposition to me.

If I were a big institution, I would be swimming damn hard upstream against consensus on private equity.

If I were a financial advisor, I would steer clear of floating rate paper, rather than reach for a bit of yield so I can tell my clients they’re insulated from interest rate risk.

If I were a distressed debt investor I would make damn sure I had access to liquidity for when these deals start to explode (indeed, many distressed funds are out seeking commitments for exactly this purpose).

The institutional investors will screw it up, because they’re organizationally incapable of swimming upstream. Most of the financial advisors will screw it up, too, because they don’t really understand what they own in a bank loan fund and they tend to fixate on past performance data, which isn’t as relevant to the current environment. The distressed debt guys and gals will make a bunch of money for a few years picking through the shattered ruins of these deals. That, I admit, warms my heart. The distressed folks have had a rough go of it lately.

This whole dynamic is a great example of how investor psychology drives market cycles. To play off that tired old hockey analogy: investors don’t skate to where the puck is going, they skate toward the player who last handled the puck.

Here the puck is going to stressed/distressed debt.

It is most definitely not going to the moon.

Who’s Paying For Lunch?

I’ve always been a fan of the old saw, “there are no free lunches.”

Not too long ago I heard this re-framed as “someone has to pay for lunch, and I don’t want it to be me.” I much prefer the second version. It underscores the fact that you can’t destroy risk. You can only lay it off onto someone dumber more willing to bear it than you.

The Wall Street Journal reports on enterprising San Franciscans gaming referral bonuses from VC-backed startups:

Elad Ossadon and Noam Szpiro, who work in software engineering, have become referring pros. In 2016, they created a website called VC Fund My Life, which catalogs discounts and freebies. When a user signs up for the startups listed, they get a referral bonus, often altered by a buzz of their phones.

Mr. Ossadon said before he started the site, he was pushing startups with bonuses on anyone he knew.

“Friends that visit here, move here—friends of friends, random people,” he said. His reward: free burgers and Thai food delivered by startup Postmates and “months over months” of free housecleanings from on-demand services company Handy.

In all, Mr. Ossadon and Mr. Szpiro estimate they have earned over $10,000 in referral credits, although many startups have started to put an expiration on the credits. “The challenge after a while became, can you use your credits before they expire?” said Mr. Szpiro, in a gray knit shirt acquired with the aid of referral credits from online retailer Everlane.

This is one of those “squishy” data points worth paying attention to. Low interest rates encourage investors to move into “long duration” equity investments such as biotech, cryptocurrency and (of course) venture capital. Even with all the talk we hear about “rate jitters” these days, capital remains cheap and cash incinerators are objects of envy.

Guess who’s paying for lunch?

 

Getting While The Getting’s Good

800px-Gluttony
Woodcut depicting the deadly sin of Gluttony, by Sebastian Brandt; Source: Wikipedia

Lately, investors have been gorging themselves on private equity. The Financial Times reports:

“The current speed of fundraising is in my experience unprecedented,” said Jason Glover, a London partner at Simpson Thacher, the law firm. “[Private equity groups] are keen to take advantage of the unusually benign conditions, particularly in anticipation of a change in market conditions when fundraisings may become significantly more difficult.”

But Mr Glover, who has been involved in private equity fundraising for more than 25 years, said investors are eager to park their cash in top-performing funds. “Investors are keen to deploy increasing amounts to private equity and with many of the top funds massively oversubscribed, their only way to secure a commitment is to act quickly before those funds are sold out,” he said.

Private equity funds have also gained traction with investors as other asset classes, like hedge funds, have underperformed, said Warren Hibbert at Asante Capital Group. He said: “The private equity market today provides a unique product which is very difficult to kill, unlike hedge funds. It’s very difficult to lose money in a private equity fund.”

Part of the public service I attempt to provide on this blog is drawing attention to screaming red flags when I see them. As far as screaming red flags go this is a pretty good one.

Private equity is simple in principle and is first and foremost an exercise in financial engineering:

Step 1: Buy cheap company.

Step 2: Add gobs of debt.

Step 3 (optional, if desired): Cut expenses to boost free cash flow.

Step 4: Flip the levered entity at a higher valuation.

The problem private equity investors face today is that they are buying into funds based on past performance that is not likely to persist. The reason? Valuations.

Remember, per the above steps private equity works the same as flipping houses. You need a cheap entry price, low financing costs and stupid willing buyers on the other side. As entry valuations rise, the bar rises on the back end. You need to find progressively dumber more optimistic buyers to exit the investment and earn an attractive return.

Dan Rasmussen of Verdad Capital has written and spoken extensively about his firm’s in-depth research into private equity returns. In a piece written for American Affairs, he discussed the negative impact of higher entry valuations at some length:

This is more troubling than most market observers understand. Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy. The importance of valuation to returns is controversial but key to understanding the asset class, so it is worth looking at the issue from a few different angles.

The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50 percent of deals done at valuations of more than 10x ebitda lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors).

The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship.

The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate ebitda of $66 billion and an aggregate market capitalization of $728 billion. The average company in this data set went public with $4 billion in market capitalization, traded for 17x ebitda, and was 21 percent leveraged on a net debt/enterprise value basis at IPO. We segmented these IPOs by valuation at IPO. We divided the universe into three buckets: companies that went public at less than 10x ebitda (about 20 percent of companies), 10–15x ebitda (about 20 percent of companies), and more than 15x ebitda (about 60 percent of companies). According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.

Included in the article is this chart comparing historical valuation multiples:

Verdad_Am_Affairs_Multiples
Source: Verdad Capital via American Affairs

As for Mr. Glover’s assertion that “it’s very difficult to lose money in a private equity fund,” here is a list (not comprehensive) of assets and strategies that wore that mantle at one time or another:

  • Tulips
  • Railroad stocks
  • The Nifty Fifty
  • Tech stocks
  • Hedge funds
  • Mortgage bonds
  • Florida real estate
  • Energy stocks
  • Bitcoin
  • Beanie Babies
  • Tesla stock

Shenanigans! Pension Plan Return Assumptions Edition

From Reuters:

New Jersey’s treasurer said on Thursday she will increase the expected rate of return for the state’s struggling public pension system from 7 percent to 7.5 percent, then lower it again over time.

The switch to a higher assumed rate means that the state, and participating local governments in New Jersey, will for now escape the higher costs that arise when investment return assumptions are lowered.

The savings come at a fortuitous time for new New Jersey Governor Phil Murphy, who took office in January and is facing a shortfall ahead of his first budget proposal in mid-March.

The higher rate will save about $238 million for the state and more than $400 million for local governments in the near term, according to the office of Acting State Treasurer Elizabeth Maher Muoio.

Color me gobsmacked. Here is a translation into plain English:

We know that our current return assumption is unrealistic. But, if we lower it outright we are going to have to make large contributions we can’t really afford (we are only 49 percent funded as it is). So we are going to tell a teensy weensy little white lie, and pretend returns will be higher for a while. And eventually we will fix the numbers. It will all work out in the end. Trust us.

Where is one to begin with something like this?

With the fact that New Jersey’s treasurer is OPENLY FUDGING THE NUMBERS?

How about some healthy skepticism regarding whether a bunch of politicians will ever adjust the numbers back down to where they belong if it means a public outcry over unfunded liabilities or higher taxes?

Or maybe the troublesome fact that only 50% of projected liabilities are funded?

Puerto Rico should be instructive where these underfunded state and municipal pension plans are concerned, both in terms of the root causes of the problems and the difficulties inherent in closing massive budget holes. This is not likely to end well for New Jersey.

Extinction

Dinosaur
Remains of a volatility short

Markets are ecosystems. And like any ecology, markets can come to favor organisms with certain traits over arbitrary time periods. In the natural world, dinosaurs flourished when the global climate favored their biology. Then, quite suddenly, that changed. National Geographic tells it like this:

Scientists tend to huddle around one of two hypotheses that may explain the Cretaceous extinction: an extraterrestrial impact, such as an asteroidor comet, or a massive bout of volcanism. Either scenario would have choked the skies with debris that starved the Earth of the sun’s energy, throwing a wrench in photosynthesis and sending destruction up and down the food chain. Once the dust settled, greenhouse gases locked in the atmosphere would have caused the temperature to soar, a swift climate swing to topple much of the life that survived the prolonged darkness.

This is not so much different from those who got wiped out holding large positions in XIV. Short volatility strategies thrived in a market environment that for years has favored long duration assets (long term bonds, high growth stocks, cryptocurrencies) and dip-buying any market decline. When the market environment changed, suddenly and violently, the short volatility trade blew up. Years of gains vaporized in a single day.

20180210_XIV_Chart

Over the past couple of years I have begun to believe there are tremendous benefits to viewing markets through an evolutionary and/or ecological lens. I think this helps you focus on a range of variables impacting the markets, versus wearing blinders that limit you to valuation, momentum, or whatever it is you consider your “thing.” So when a particular asset class catches a strong bid, here are some things I consider:

If this is a cash flow producing asset, what is the relationship between the intrinsic value of the cash flows and the market price? For stocks it is not especially difficult to use the market price and a simple DCF model to derive a market implied IRR. For bonds just check the yield to maturity, yield to call, yield to worst, etc. This gives you an idea of how investors are pricing risk.

Who is driving flows into or out of a sector or asset class? Mutual funds look at the world differently from hedge funds, which look at the world differently from banks and insurance companies. Each of these players has different objectives and constraints, which will impact their behavior as market conditions change.

Are the players driving flows into the asset weak or strong hands? Retail investors are the weakest hands in the markets. I consider many mutual funds weak hands also (depends on the fund family). Mutual fund flows are driven by retail investors and their financial advisors, who are notorious for chasing performance.

How highly levered are the players driving flows into the asset? Leverage can drive extraordinary returns, but it also creates fragility. When deleveraging events occur, prices can collapse suddenly. Many of the short volatility players who got blown up recently didn’t understand the magnitude of the leverage embedded in their positions.

What exogenous factors are driving flows into this asset class? Is an asset in demand due to expectations for low interest rates, low inflation, or other macroeconomic variables? Macro conditions are fickle, and human beings are notoriously poor forecasters.

The most fragile market ecology is one where weak hands are using leverage to play some exogenous variable with known unstable or mean-reverting properties. From this perspective, systematically shorting volatility was stupendously risky–a form of Russian roulette. A large number of retail investors were trading instruments (volatility linked ETPs) with significant embedded leverage, placing a massive directional bet on low rates, low inflation and market momentum.

A market ecology I believe is extremely fragile, but hasn’t blown up yet, is high yield debt. This is an asset class that is highly leveraged by definition, and has attracted massive flows from yield-starved investors. Strong flows have pushed prices up to the point where future expected returns are dismally low, and protective covenants are the weakest on record. Perhaps worst of all, there is a liquidity mismatch between the ETPs (HYG, JNK, etc.) providing investors with easy access to high yield debt and the underlying high yield bonds. For a preview of what happens when a liquidity mismatch meets a stampede for the exits, refer to Third Avenue Focused Credit.

Next stop: Adaptive Markets by Andrew Lo.