Outside-the-box risk control = Better returns

• Mis-specifying investment objectives and risk preferences
• How to take advantage of volatility
• Regime change risk in the form of:

1. Unexpected tail-risk
2. Changes in market environment (conventional regime change);
3. Slow changing regimes that investors may be unaware of;
4. Changes in modeling assumptions.

The right and wrongs reasons for trading

1. It’s money you can’t afford to lose. 
2. You have no idea what you’re investing in or why.
3. You’re buying purely based on emotion.
4. You have no idea what tendies are.
5. You have a family or other financial responsibilities that are more important than putting on a YOLO trade.
6. You’re buying a stock because you saw someone talking about it on social media.
7. You’re buying a stock because one of your friends owns it.
8. You have no idea when you will sell it.
9. You’re revenge trading. 
10. You don’t understand the risk involved in the stock market.

Take advantage of volatility

Increasing (decreasing) investment in an actively managed mutual fund when fund volatility has recently been low (high) leads to a significant improvement in investment performance. Specifically, volatility-scaled fund returns exhibit significantly higher alphas and Sharpe ratios than the original (unscaled) fund returns. Scaling by past downside volatility leads to even greater performance improvement than scaling by total volatility. The superior performance of volatility-managed mutual fund trading strategies is attributable to both volatility timing and return timing. Fund flows are negatively related to past fund volatility, suggesting that fund investors are aware of the benefit of volatility management.

Beware of regime changes

Tail-risk of widespread deaths

Given these empirical results, we can reject the null of our hypothesis that financial market returns will be negatively correlated to conflict mortality for both fixed income markets and the blended 60/40 portfolio. For equities alone, the result has the correct sign but is not significant on eleven observations. We can also confirm that fixed income markets are more acutely impacted.

Our empirical investigation began by calculating the ratio of equity market cap to GDP for a sample of about 100 countries for 2012. The correlation of market cap/GDP to the corruption index was negative 45% (r-squared = .21) which is highly statistically significant (T > 5). We repeated the analysis annually starting with 2002. In this case, the number of countries with functional equity markets was only 82, but the correlation of the market cap/GDP ratio was even higher at [negative] 48% (r-squared = .23) which is also highly significant (T > 5).

In some ways, the phrasing of “climate change risk” is a misnomer. In financial markets, the word risk is often used as a proxy for uncertainty. There is little uncertainty about the direction of what is happening in climate. The “risk” is in what the economic effects will be. Against a background of natural variation in temperatures over centuries, the increasing existence of greenhouse gases in the atmosphere has biased the process of global temperature variation toward increases rather than decreases. The world is being made hotter by some amount, and the increased energy levels associated with this greater heat is manifesting in various ways including higher intensity and frequency of extreme weather events. While it will take hundreds or thousands of years to prove to a statistical certainty that the recent changes in average temperatures are the result of human activity, the increasing concern of investors with respect to the environment is clear.

The most obvious question facing investors is the future of fossil fuel production and consumption which is widely accepted as the single largest cause of global warming. The most basic question is whether to reduce or eliminate investment in oil, coal, natural gas, and other fossil fuel related enterprises. The first research on this point was published nearly a quarter-century ago. In diBartolomeo and Kurtz (1996) a detailed analysis is done to attribute performance differences in an equity index which had been “screened” for environmental effects against a similar but unscreened equity index (the S&P 500). At the time, approximately 80% the variation in relative performance could be attributed to the inclusion or exclusion of fossil fuel related firms. This study was subsequently updated in diBartolomeo and Kurtz (2011) with similar conclusions. Both papers also illustrate how investors could change company level weights in their portfolios so as to minimize the variations in relative performance over time. 

Modeling regime change

We start our analysis with an examination of the question of the adequacy of the P/B measure to capture the value effect in today’s economic environment. The economy has rapidly moved from agriculture to manufacturing to a service and knowledge economy. Therefore, we have economic reasons to believe that simple measures of value, such as B/P, are problematic. For example, a company presumably undertakes the creation of intangibles (e.g., research and development, patents, and intellectual property) because the managers expect these investments to enhance shareholder value. These investments are typically treated as an expense, however, and are not accounted for as amortizable assets on the balance sheet, which effectively lowers—we would argue understates—book value by the amount invested in the intangibles…Many of these stocks would have been classified as neutral or value stocks if the value of the internally generated intangible investments had been capitalized, thus increasing book value.

In other words, value investing, as measured by P/B, is misspecified. Arnott et al found that adding back intangibles improves the performance of value stocks (where HML stands for book-to-market minus low book-to-market).
 

Using alternative measures of value, the authors of the study found that other metrics performed better than the book-to-price ratio.
 

My conclusion from this to means that value investing isn’t dead. The dispersion of low and high P/E stocks is highly elevated, indicating that there are opportunities in value investing. The last time the market saw such a high level of P/E dispersion was at the end of the dot-com bubble and shortly thereafter. Growth stocks tanked, and value stock soared then.
 

In conclusion, instead of focusing on sources of alpha from stock, sector, or country selection, investors can also add value through better risk control by some “outside the box” analysis of the risk framework. In particular, investors can think about the following: