“Measuring Unobservable Risk”

Posted on by David Wright

That is a paraphrasing of the title of an article in an issue of CFA magazine I found around my apartment. It caught my attention. Particularly because I’m inclined to think anything that makes that sort of claim is either BS or dangerously misleading.

So here’s the mechanism to the ‘omega-score’:

  1. Correlate returns data to ‘operational issues’ (“These include criminal, civil, and regulatory issues.”) disclosed in a regulatory filing *some* hedge funds have to make.
  2. Establish that funds with these issues perform poorly. No surprise. They use something called ‘canonical correlation‘, which assigns weights to a set of variables (‘operational issues’) and tests their weighted effect on returns. Without reading the paper, it’s tough know what the ‘omega-score’ is, but it’s probably some kind of representation of the correlation.
  3. Now find some data that is publicly disclosed by all hedge funds. These are the new variables.
  4. Test various correlations that match the profile of the #2 variables. This is how we set some kind of statistical equivalence between the variables we know have an effect on the returns (from #1) and those we suppose have an effect (the ones that are always disclosed).

That ‘canonical correlation’ thing is a clever technique that I don’t know much about. One thing to watch out for is that we’re talking about establishing a statistical artifact that has no direct intuitive basis.

In other words, there’s a difference between saying “hey, I think that these two or three variables will have an effect on returns” and saying “hey, these variables might be related to these other variables that probably have an effect on returns”. Gets messy.

And the focus is a bit confusing. What we’re really doing is correlating ‘operational issues’ with variables that heretofore had not been associated with that kind of nastiness. If I’m right that that’s what we’re doing, I’d have two questions:

  • Why do we need to do this for each fund individually? If variable x is associated with bad behavior at one fund, wouldn’t it be similarly associated at another?
  • Aren’t the findings of the correlation study interesting in of themselves? If you can get better at figuring out which funds are in legal trouble, why risk building a statistical white elephant trying to link it to returns results?

Anyway, really interesting stuff. This kind of study demonstrates the power of even modest bits of information if they’re consistently and universally disclosed.

Smartphones and Concerts

Posted on by David Wright

Went to The Today Show the ohter day and heard Journey play “Don’t Stop Believin'” no less than three times. Now that’s a band that’s not scared of playing its hits!

We were standing somewhat towards that back of the crowd but it wasn’t a large crowd and we felt good about our line of sight to the elevated stage. Then the band came out and this is what we saw for the duration of the (very short) set:

What are we seeing here? Smartphone viewscreens and the backsides of signs telling Journey how much they are loved from various obscure parts of middle America is what.

Disappointing? Yep. But there were some good moments, nonetheless. For instace, we awarded the innovation prize to this guy:

It’s a little tough to see, but we have a camera raised up by its tripod for a clear look at the band. Brilliant, right? Well, unfortunatley, our erswhile videographer couldn’t see his camera viewfinder (and we could) and he was only recording the crowd about 15 feet in front of the stage.

The point is that cameras and video recording devices prevented most of the crowd from actually seeing the show. I figured what’s going on is that a few people up front, who can see just fine, hold up their phones or a little personal memento. The people behind them do the same.

After a few rows of this, though, the people who can’t see easily hold their phones higher and higher up. Once we get to the poor suckers at the back, their only hope of ever seeing the show now lies in watching a video on our smartphones when we get home.

It’s too bad, but at least we got to hear the hits.

What We Want In An Expert

Posted on by David Wright

I’m a big fan of Arnold Kling and Nick Schultz and I think there are a lot of interesting things in this article.

One thing that is nagging at me, though is this:

Perhaps medical services could be delivered by workers with fewer credentials but more rigorous on-the job training… Healthcare providers would be accountable for the quality of their work, not for the certificates hanging on their walls.

When I read that I think of the ways that current healthcare providers are and are not accountable for the quality of their work and wonder at what incremental change might occur on this dimension with the kinds of reforms K&S fantasize about.

Let’ say that people choose their healthcare provider based on reputation, credentials and leave the non-reputational consequences of ‘bad work’ to malpractice insurance and the Reviled Employment Certification Boards.

I’d imagine A&S expect this model to remain intact and might say they’re just enhancing the reputational feedback loop. Perhaps, but I think that, deep down, they really want to dismantle the credentialist evaluation model (ie the “He went to Harvard therefore he’s smart therefore he’s a good doctor therefore I want him for my doctor” model).

I’d like to think about this credentialist problem using a different field I know something more about: financial services.

I’ve actually come to think wages in financial services are high for one simple reason, which I’ll express in the form of a question: “If you had a bunch of money, would you rather pay someone really smart (smarter than you) to manage it or someone not as smart?”

And everything else comes from that. You want someone smart. How do you know he/she is smart? Look at the track record. It’s ok but he’s
pretty smart and convinced you that his record will improve. Okay…  Oh, look! He went to Harvard so he must be smart. Done

Now this smart guy has your money and gets paid really well because he’s smart and you’ve got to lure him away from doctoring, laywering,
physics-ing or whatever and he’s smart so probably figured out a way to screw you just a little bit. Hopefully he can screw some other
people on your behalf now, too!

Now this smart guy makes lots of money so will be happy if the other guys and gals who bring him deals make lots of money, too. They’re
doing most of the “work”, anyway. He mostly just brings the money to the table and evaluates the ideas. Bam! Big banker bonuses are born.

And this smart guy is really rich and really knows his stuff so he gets lots of access to people who don’t know his business that well but thinks what he does is really important and have the power to help/hurt him. And, hey, he’s smart and charming so he spreads the love a bit and these powerful types really trust him now. Bam! Regulatory capture.

And this smart guy seems to have wormed his way into a central part of the financial system. A part that is so critical, we have to have people everyone thinks are the smartest guys in the room.

K&S aren’t likely to change how we evaluate who we think the smartest guys in the room are and that means credentials play a role along with track record.

Even for doctors.

 

Brain Science

Posted on by David Wright

That’s a non-ironic title (this time).

Here’s Robin Hanson:

It persuades me that raw brain hardware was more important than I’d thought in our history.  Here is my current best guess on brain history.[..]

The added ellipsis is my attempt a building some tension there. If you have any interest in evolution or anthropology (I wish I could make that sound less pretentious), read the link. I know about 30% of what I’d need to know to comment intelligently.

The Science of BS (Meta BS?): It’s All BS, Mostly

Posted on by David Wright

Opinions are mostly made up on the fly:

For example, in two surveys spaced a few months apart, the same subjects were asked about their views on government spending. Amazingly, 55% of the subjects reported different answers. Such low correlations at high frequencies are quite representative.

And here’s Robin Hanson:

If you talk a lot, you probably end up expressing many opinions on many topics. But much, perhaps most, of that you just make up on the fly.

BS is something the BSer thinks will sound plausible. It lacks thought behind it because thinking is hard work. A BSer isn’t trying to be a Truth-Seeker, he’s trying to signal intelligence.

What’s interesting about BS is that people have different abilities to detect it, you might call them greater or lesser bull-takers. The grand hope of a bullshitter, of course, is he’s found himself chatting with a bull-taker who will just take it.

Bullshitting (as a phenomenon) is relatively easy to figure out, I think.

But what’s the theory of bull-takers? Why is listening so hard?

Soros Is Out

Posted on by David Wright

CNBC harped for a few minutes this morning about how Soros no longer manages money for other people. A few angles were pointed out:

  1. How does a DEMOCRAT bemoan regulation?!
  2. Why do we care what Soros does?
  3. Wait, 24.5b? I thought he only had 15b?

They also made a strange point, which I haven’t been able to find backup for online, so beware. They said that Soros parks some of his money in other hedge funds and that he isn’t likely to pull that cash back to himself.

Strange, isn’t it? He hates the regulation as a manager but is happy to live with it as an investor.

Is there a ‘there’ here? I’m not sure.

So What Is Default, Anyway?

Posted on by David Wright

Here is Felix:

ISDA has made the right decision: the Greek bond default does not and should not count as a “credit event” for the purposes of whether Greek credit default swaps will get triggered.

As Felix rightly points out, if you take a 21% haircut on your bond principal and can’t call that a default, what good is CDS protection?

A few years ago, just about every reinsurance broker in the world (us included) was looking at CDS as a way of hedging insurers’ exposure to reinsurance recoverables in the event of reinsurer insolvency. It only took a few days’ work to realize the whole thing was useless.

The problem in insurance is that reinsurers don’t go into ‘default’. They go into something called “run-off”.

Insurer obligations are fundamentally negotiable. If an insurer declares itself ‘in runoff’ (ie it is accepting no new business) it has signaled its financial weakness and warned claimants that the pot might run dry before they get paid. Suddenly a claimant will accept 0.80 on the dollar for fear of getting even less later.

Well, that improves the solvency of the insurer but the people owed money get screwed.

Bankers tend to feel pretty smug about their black-and-white default definitions because the cross-default provision lets most lenders push the big red button when they get miffed. Looks like the Eurocrats have got that one sewn up somehow, though. Oops.

All anyone really wants is protection against principal reductions on what’s owed ’em. Throw in a bit of relief from the legal nonsense of squeezing your last few pennies out and you’ve got yourself a product.

Problem is, this is a product that doesn’t exist.  In any financial market, it seems.

The Present

Posted on by David Wright

Tyler Cowen links to this paper and quotes from it:

Most service production is consumed domestically and virtually all public services are not traded…the most remarkable structural change in the Canadian economy is that Canada was less integrated in world markets at the end of 2006 than it was a decade earlier measured by intense export openness

I didn’t read it. The point as I see it is that non-resource Canada is becoming a service provider to itself.

So, in caricature: Canadians trade energy, minerals and timber for manufactured goods and swap food with California and Chile. Mostly, though, Canucks just scratch each others’ backs.

Meet Your Insurance Broker: Google

Posted on by David Wright

Insurance is the most expensive keyword money can buy.

This is GEICO and Progressive showing us that insurance distribution is extremely valuable. Those local brokers’ salaries are now being paid to Google engineers.

Advertising is expensive, though, and you need scale for this business model to work.

US Auto liability works fine, but it is both the biggest and most standardized insurance market in the world. It is the exception that proves the rule that an insurance broker is an economically useful advocate.