Happy New Year

May you all find peace, prosperity, health, and happiness in 2019.

AQR Capital Management, 20 for Twenty

A heads up to anyone who wants to understand how some very bright quants think. I just downloaded AQR’s anthology commemorating its 20th anniversary. It’s big, coming in at nearly 700 pages, and free for the taking in either .mobi or .epub formats. Personally, I can’t think of a better way to spend part of the holidays than reading the 20 papers that “have formed the backbone of AQR’s investment philosophy.”

Jacobs, Too Smart for Our Own Good

Bruce I. Jacobs’ Too Smart for Our Own Good: Ingenious Investment Strategies, Illusions of Safety, and Market Crashes (McGraw-Hill, 2018) attempts to identify the common causes of financial crises since the 1980s. Jacobs, the co-founder of Jacobs Levy Equity Management and its co-chief investment officer and co-director of research, believes that underlying all of these crises have been “free lunch” products that, in turn, have their roots in the Black-Scholes-Merton option pricing model.

Jacobs focuses on three crises and the allegedly risk-reducing, return-increasing strategies and products that led in these cases to market instability and massive losses, at least in the short term. “Of particular interest are portfolio insurance in the 1980s, arbitrage strategies pursued by LTCM in the 1990s, and the mortgage-linked securities at the center of the 2007-2008 credit crisis.” Jacobs contends that they share certain commonalities. “These commonalities include opacity and complexity, which make it difficult to anticipate the effects of the strategies and products and to discern the relationships they forge between different market participants. They also include leverage, facilitated by derivatives and borrowing, which increases their impact on security prices, markets, and the economy. And they include the underlying, option-like nature of the strategies and products, which can make markets behave in nonlinear ways, with prices bubbling up or crashing down.”

One of the major problems with products that purport to reduce risk and increase returns is that they tend to encourage more risk-taking since people believe that, with these products, they have a safety net come what may. Moreover, as the demand increases for such products, “the level of risk that must be shifted increases. The availability of counterparties to take on the risk becomes more and more questionable. Liquidity begins to dry up.”

Jacobs does not argue against option, arbitrage, and securitization strategies in general. He recognizes that they can play a useful role in portfolios. He also recognizes that the crash-inducing strategies and products of the future will be different from those that caused problems in the past. He remains convinced, however, that they will share the same fundamental characteristics. Forewarned is forearmed.

The best books of 2018

Another year, another idiosyncratic list of what I consider to be the best books I reviewed this year, with links to my reviews.

Michael Batnick, Big Mistakes

Cochrane & Moskowitz, eds., The Fama Portfolio

Annie Duke, Thinking in Bets



Sebastian Edwards, American Default

Meb Faber, The Best Investment Writing, vol. 2

Howard Marks, Mastering the Market Cycle



Michael Rees, Principles of Financial Modelling

Howard Schilit, Financial Shenanigans, 4th ed.

Paul Volcker, Keeping At It

Ochoa-Brillembourg, Delivering Alpha

Delivering Alpha: Lessons from 30 Years of Outperforming Investment Benchmarks (McGraw-Hill, 2019) by Hilda Ochoa-Brillembourg is written for “any finance professional who wants to know how to add sustainable value to globally diversified institutional portfolios beyond what’s learned in textbooks.” The author, after an 11-year stint at the World Bank as chief investment officer of its Pension Investment Division, was the lead founder of Strategic Investment Group in 1987 and continues to serve as its chairman. Since its founding, Strategic has outperformed its benchmarks more than 75% of the time on a rolling three-year basis with less volatility than the benchmarks.

Ochoa-Brillembourg is primarily concerned in this book with institutional portfolio construction and management. Although she acknowledges the many merits of modern portfolio theory, she writes that “in practice there is significant slippage between the practical lip and the theoretical cup. Principally, the optimal portfolio will change dramatically over time with the volatility of the assets it contains and the return and risk preferences of investors and securities issuers. Market variables are unstable, and most investors have significant risk and return constraints, forcing them to engage in exercises of ‘constrained optimization’ that will move away from the most elegant MPT concepts. Life is messy and hard, and so are optimal investment choices.”

She dubs her optimal portfolio construction theory “portfolio fit theory.” The process of improving the return to risk profile of a legacy portfolio (assuming that most assets in the portfolio are either worth preserving or inefficient to liquidate) involves adding marginal assets. “In this framework, the value of an asset needs to be assessed on the basis of its price, its expected return, its volatility of return—and, most important, its correlation with the legacy portfolio, not solely its correlation with the market portfolio.” And, an important corollary, the fair market price of an asset does not equal its value to a particular investor. “Certain assets may have a higher value to particular investors than their market price, and some assets can improve a legacy portfolio’s return-to-risk ratio and compound rate of return despite apparently suboptimal characteristics on a stand-alone basis.”

Ochoa-Brillembourg covers a lot of ground in this book, from selecting appropriate benchmarks to rebalancing versus tactical tilts, from the uses of volatility to the boundaries of risk. A sub-theme is governance. (It seems that her group has dealt with more than its fair share of clients who had less than ideal structures in place for making decisions.)

Delivering Alpha is brimming with the kind of practical wisdom that comes from years of experience in the trenches. Money managers of all stripes will profit from reading it.

Edmondson, The Fearless Organization

Twenty years of research inform The Fearless Organization: Creating Psychological Safety in the Workplace for Learning, Innovation, and Growth (Wiley, 2019) by Amy C. Edmondson, a professor at the Harvard Business School. Although by now most managers know, at least in theory, that they should provide an environment in which workers at all levels can share their ideas—and mistakes—without the fear of belittlement or reprisal, not enough managers know how to put this into practice. A 2017 Gallup poll found that only 3 in 10 employees strongly agreed with the statement that their opinions count at work.

Edmondson’s work bridges this gap between theory and practice. With findings from academic research and case studies from a wide range of workplace settings, she explains how to build an organization in which learning, innovation, and growth can flourish.