### capital markets

QE3 was announced today and reactions have been relatively muted. There are some complaints that money is again being redistributed from asset holders to debtors via the mechanism of negative real rates. It seems like a good occasion to put forth two oddities that I’ve always seen as embedded in capital markets as they’re currently constructed. They are: the assumption that money doesn’t spoil, and the assumption of market optimality.

I mentioned this to an officemate years ago once, but I never was quite satisfied with the explanation that there is a certain amount of excess return built into the price of a company’s stock as its risk premium, but which can be diversified away through some portfolio of disparate stocks.

If, merely by holding a diversified portfolio, the aggregate risk can be reduced, then one would expect the return demanded for such a portfolio to be less than the sum of the returns of the individual stocks. Yet this is not the case. So we must assume either the portfolio is overperforming, the individual stocks are underperforming, or both. On the other hand, it would seem that the risk premium of any individual stock would be arbitraged away by people holding the most diversified portfolios containing it, thus it is strange that an individual stock could retain an undiversified risk premium. Thus it must not, at least not fully. Its return (and the price it sells for) is also determined by the availability for sale of other not-fully-correlated stocks and their characteristics, even ones that have no material effect on the company’s performance. This is a sure sign of value arising from the demand for the instrument unrelated to its underlying. It would seem to be mispriced as an individual stock. Perhaps an equilibrium will be struck, but it is still paradoxical to talk about the risk premium of individual stocks as a property of that stock alone.

### Long the leveraged market portfolio?

This guy proposes the use of a 2x leveraged market ETF to “beat” the market in the long term, assuming the market goes up in the long term (that is, the value of the mean path at a much later time is higher, or, perhaps just the marginal expected value is higher at a much later time).

It seems like a nice idea, but something is off. Firstly, these are leveraged portfolios with forced daily rebalancing, so depending on the amount of daily price variability, there is a non-trivial loss of several percent a year on top of costs. If a long-term leveraged position is wanted, one may as well buy the appropriate derivatives that underlie these ETFs, if that can be done.

Secondly, leverage is not free. This WSJ article nails the fixation on returns …

Until recently, public companies, mutual funds and pension funds generally steered clear of such risks. But the lines between risk takers and mainstream investors are blurring. In part, that’s because stock-market returns aren’t what they were a few years back. Between 2000 and 2006, the average annual return on the S&P 500 stock index was 2.5%, down from 28.7% between 1995 and 1999. Using derivatives and borrowed money is one way to try to boost returns.

… but although the return is better, the risk-adjusted return is more useful to look at. With true 2x leverage, only the risk premium is doubled at best, not the total return. On the other hand, if true 2x total return is supplied as they say, the implied leverage, and hence risk, has to be much higher than 2x. That’s something to look out for. Granted, the amount of leverage can be adjusted by weighting with the 1x portfolio.

### the market efficiency cult

I actually find market efficiency arguments quite appealing, but when the assumptions are not made clear, the inevitable hand-waving gets to be irritating…

Here’s some random guy’s page. He’s a big proponent of using a total market portfolio: http://homepage.mac.com/j.norstad/finance/total.html

His hand-waving is almost convincing, almost. Okay, “J. Norstad”, let’s take you point by point.

China Forming Fund to Invest Reserves
Friday March 9, 2:24 pm ET
By Joe Mcdonald, AP Business Writer

Here’s an excerpt

The growth in China’s reserves is driven by the rapid growth of its exports, which brings in dollars, euros and other foreign currency, and by the billions of investment dollars being poured into the country.

The surge in money flooding in from abroad forces the central bank to drain billions of dollars from the economy every month by selling bonds in order to reduce inflationary pressures.

The precise composition of China’s foreign currency reserves is a secret. But economists believe that as much as 75 percent is believed to be in U.S. dollar-denominated instruments, mostly Treasuries, with the rest in euros and a small amount in yen.

Stephen Green, chief economist at Standard Chartered Bank in Shanghai, calculated that last year the central bank made a $29 billion profit on its Treasury holdings after paying interest on its own bonds and other expenses. But even that represents a return of less than 3 percent on the$1 trillion in holdings.

By contrast, Singapore’s Temasek says it has averaged an 18 percent annual return since it was created in 1974.

When a country sells more than it buys, and when other people make investment (gives the country a loan), the excess money ends up parked somewhere, in this case, at the central bank. According to this article, the central bank takes this money and invests it in US Treasury Bonds, but is looking for other investments. But it also mentions, as a separate matter, the central bank sells its own bonds (denominated in RMB, presumably) to absorb excess RMB. But the selling of bonds is not much different from offering a time deposit account, so all that the central bank does is to encourage more savings in it. The intention to remove excess money means the government has determined that the economy can’t bear any more production/investments so that investments should be made to external projects. But it’s strange that the central bank can pay its bonds and still get 3% additional return on behalf of the depositors (which it keeps). Why wouldn’t people just invest in US Treasury Bonds or whatever other external investments themselves? Is it due to the non-convertibility of the RMB? Or is it something else?

In fact, why does any country end up with a huge reserve, even ones with convertible currencies? Some reserve for safety is understandable, but a huge reserve must mean that its people just like to save save save. But why do they like to save? It must be because they have low risk tolerance as individuals — that makes them seek out the government as an investment fund? If so, then it only makes sense for the central bank to leverage its large funds to make risky but diversified investments to give its depositors a high return at a still tolerable risk. In that case, it makes sense that China is making adjustments to its reserves investment policy away from the completely safe US Treasuries, ahead of any further loosening of RMB convertibility. That way, when convertibility arrives, the reserves will be competitive enough to remain large enough for the government to still have its monetary levers on the economy.

In contrast, the US sells less than it buys. But the US Federal Reserve is still awash in money. It gets money from the rest of the world well in excess of what would be the usual investments in the US economy, due to the status of the dollar as the world’s preferred reserve currency. So even with large deficits and lack of savings, the Federal Reserve still can do what it needs to do — and this includes handing out cheap loans to the US government and banks (and indirectly, consumers). Nice.