(click to enlarge)I received a copy of Phil DeMuth's Affluent Investor, which at around $11 is a bargain. Alas, advice books like these, for the layman, are kind of futile, as good advice is ignored by those who need it precisely because those who need it would never seek it. So, it's best as a gift. If there's a 10% chance they can learn, it's worth $11.

For example, DeMuth nicely informs the reader what investment advisers think is wealthy: $100k to $1 million is 'affluent', $1MM to $10MM is 'high net worth', above that is 'ultra high net worth'. From a practical perspective, one should target getting 25 times one's income when one retires, probably a good definition of 'comfortable.'

He makes the interesting point that gambling is fun and savings is hard. But savings, investing, and gambling, are all different shades of grey, and highlights that

There's an interesting video where several of the world's most esteemed monetary experts got together to honor ex Bank of England Governor Mervyn King, and in the process acknowledged they needed a financial mechanism that affects the general economy. They can't figure it out exactly, they just know finance is very important to the economy.

In the meantime, they continue to countenance, if not encourage, the persecution of banks. Every quarter there's a new lawsuit brought against the banks. The news Tuesday night was about the Libor scandal, which, surely needs punishment, but it's just getting old and the damages are unlimited, so banks are naturally wary. Can we fast track these things? Add to this that regulators are giving banks extra scrutiny for everything they do, and naturally most banks are afraid to lend. Thus, all this new money

Uncovered interest rate parity suggests that currency returns should relate to interest rates in a pretty straightforward way. For example, the short-term interest rate in American dollars is about 0.25% and the comparable rate in Australia is 3.0%. According to the uncovered interest rate parity, the Australian dollar should depreciate against the American dollar by approximately 2.8%. Put another way, to convince an investor to invest in Australia when its currency depreciates an expected 2.8%, the Australian dollar interest rate would have to be about 2.8% higher than the American dollar interest rate.

On average, however, the high interest rate currencies actually appreciated. If you borrow in low interest rate countries, invest in high interest rate countries, you simply make more money and no one has found a risk metric that might explain this. It's another example of

Some note that if we are in bull markets, it is better to be in high beta stocks. I would agree that if you know you are in a bull market--that is, you know the stock market will be up at the end of this month--then it is preferable to be in high beta stocks. Yet, implementing this timing rule is not straightforward because even abstracting from the variance drag of high volatility stocks, the dominance of low vs. high beta changes whether you are using contemporaneous or ex ante indicators. That is, it makes a big difference if you use data from today to determine tomorrow's portfolio, or data from tomorrow night.

Low vol is pretty much like low beta. and betas are actually pretty straightforward to predict. Low beta stocks move less than high beta stocks. In up markets, low beta stocks go up less than the average,

I read The Signal and The Noise because I got two copies as Christmas presents. It was an enjoyable read; like popcorn in that while I liked it afterward, I wasn't very satisfied.

There were some neat anecdotes, like about how the McLaughlin Group's forecasts were about 50-50, but I didn't think it meant these guys were clueless so much as McLaughlin was basically asking for opinion where the true probability is about 50-50. As Steve Sailer notes, no one wants to hear depressing statistics like the murder rate in Detroit will be higher than the suburbs, or that per capital income in Somalia will be lower than in Estonia in 2010 or lots of other really important facts about the future, because we take those for granted. Instead, we want to know if Apple (AAPL) iPhones will be more popular than the Samsung (SSNLF.PK) phone, which is more

The U.S. budget deficit has been large for quite a while, and there doesn't seem to be a lot in terms of revenue increases or expenditure cuts in the pipeline. Consider that in the latest budget deal, tax hikes will raise $22 billion this year, while the special-interest business and energy tax credits will reduce revenue by $65 billion.

Thus, I was surprised to see this chart from our non-partisan Congressional Budget Office around the Internet, showing a mysterious big decline in the Federal debt/GDP ratio starting in about a year:

So, what's going to cause this trend to reverse course in a few months? Two things. First, the Federal deficit is projected to basically halve every year for the next couple, getting to around zero in five years. As mentioned above, the profiles in courage recently displayed should give one pause, especially considering how

Christmas traditions have gone from stockings and exchanging gifts, to fruitcakes, bad sweaters, NBA games, and now Taleb books, a sign that perhaps the Mayan return isn't so much an apocalypse but rather a mercy killing. Taleb is one of many best-selling authors I don't enjoy (Tom Friedman, Robert Kiyosaki, Snooki), but as he is prolix, pretentious, petulant and clueless, I enjoy commenting on his latest blather (my review of Black Swan here, Bed of Procrustes here).

His latest book 'Antifragile: Things That Gain from Disorder' is driven by his discovery that there is not an English word for the opposite of fragile, which he thinks could not be 'robust' (this neologism is one of the few new ideas presented in this book, not that I think we need more new Taleb ideas). Fragile things lose a lot of value when mishandled, 'anti-fragile' things

Frazzini and Petersen, the duo behind AQR's Betting Against Beta theory behind the low vol anomaly, have a new paper out on embedded leverage. Their theory is basically that investors are constrained in their allocation to equities, so overload on those equities with the highest betas in order to get more equity exposure. The paper looks at both levered ETFs, and options (from 1996-2010). Here's a graph showing the embedded leverage (aka omega) in options, and monthly returns.

Monthly Returns (y-axis) and Option Omega (x-axis)

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This adds more data to the fact that options are not just bad investments, but worse the more out-of-the-money they go.

Eugene Fama states that the low volatility anomaly is really just the excess return low beta, and this has been well known for 50 years. I think it's indisputable that low beta underperforms high beta, but I guess that's a fun fact of contention. It's fun to find yourself on the minority side of a fact you think others don't agree with.

His mention of 50 years can only mean that the Security Market Line (i.e, relating beta to average returns) is insufficiently increasing, positive but not as much as theory suggests. That's one implication of the low volatility anomaly, but it's much worse than that. The Low Volatility anomaly targets two things Fama can't admit: the Security Market Line is negative, and the essence of low vol investing is vol, not beta.

Here's the total return on three portfolios: the aggregate market, the top 1500 stocks (in market

My 5-year old daughter recently was very excited to discover a new solution to a pressing problem. Her mother had told her she was not allowed to eat cookies and left the room. Five minutes later, Izzie told me she had a great idea: I give her a cookie but we don't tell mom, so mom wouldn't be upset. Win-win! Her pride in independently discovering the tactic of lying reminded me that many skills are no less interesting to others simply because I know them. Such it is with Michael Mauboussin's book, The Success Equation, which investigates how to navigate in a world filled with skill and chance.

The book spends a couple pages explaining the reversion to the mean by noting Galton's original observation on the heights of parents and their children, and much of the book involves the concept of bayesian updating. These aren't new ideas.

Recent increases in the monetary base have all gone into excess reserves, and so inflation has remained low, and monetary stimulus isn't stimulating. This puzzles many people, but I have a theory for it. The idea is that while equity owners--management--are like owners of call options on the assets of a firm (aka the Merton Model), banks are like down-and-out call option owners, because if their book equity goes down too far, they will be forced into a fire-sale or liquidated by regulators.

This is a barrier option, and has the interesting property that its vega--the derivative of the value of the equity with respect to asset volatility--is negative when it gets close in value to its barrier. A standard call option loves volatility, the greater the better. This can be shown by noting that an option is worth something like max(0,x), where x is

Scott Patterson's new book, Dark Pools: High-Speed Traders, A.I. Bandits, and the Threat to the Global Financial System, suggests a Rolling Stone type of expose of vampire squids sucking the vital fluids out of widows and orphans. In contrast, most of the book was about the development of electronic exchanges from 1990 through 2007, especially focused on the firms Archapelego and Island. It reminds me of Justin Fox's Myth of the Rational Market, which suggested a rather slanted and damning hatchet job but then did nothing of the sort. I suppose the marginal business book buyer is on the way to an Occupy rally.

I work on tactics related to these tactics and technologies, so I found it very enjoyable. The real hero of this book, rightly, is Joshua Levine, who started Island. He pioneered paying for flow, where one pays those making markets, and charges those crossing

Pimco maven Bill Gross recently warned that both equities and bonds look headed for a bad intermediate future. He makes the interesting observation that as labor income has declined over the past century, this allowed capital to reap more reward than what is merely in GDP growth (see chart below). Yet, this cannot continue any more than bonds can appreciate from lower yields. The result is pretty scary, because as Gross points out, a 4.75% asset return premium needs about a 7% growth from equities if bonds are going to generate 2% returns, and if this won't happen, CalPERS and many of its ilk are in serious trouble.

Click to enlarge:

Ben Inker of GMO responded by noting two points. First, one doesn't see much relation from developed or developing countries between equity returns and GDP growth, over many decades. This is really interesting because most general equilibrium

PowerShares rolled out a pair of ETNs offering inverse exposure to Japanese government bonds, the 3x Japanese Government Bond Futures ETN (JGBT), and the 3x Inverse Japanese Government Bond Futures ETN (JGBD). Government bonds are typically considered low risk, but to generate sufficient demand, it appears you need to lever them so they have high enough risk to warrant interest. I suspect that in 10 years, everything will have a 2x and 3x derivative that's tradeable on liquid exchanges.

Now, one reason for the demand is that accounts like 401Ks discourage leverage, so the leverage is implicit in the ETF, and not explicit. This is a big problem with leverage limits because leverage can always be gamed in this way, and there is no simple solution.

But I suspect the main reason is more fundamental: People like volatility, and so demand increases with higher volatility. Now, in most formulations,

Robeco's David Blitz addresses the low-vol anomaly by looking at an alternative to the Fama-French 3 factor model that basically assumes equity managers are all benchmarking (see Agency-Based Asset Pricing and the Beta Anomaly). If true, the relevant metric of risk is not total return volatility, but rather benchmark volatility, where the benchmark is the market. He calls this an 'agency based model' because the standard principal-agent problem here is the investor (principal) gives money to the portfolio manager (agent), who then invests with his perverse benchmark concerns. There are a lot of anecdotes and data to suggest that institutional portfolio managers are evaluated based on their benchmark volatility, regardless of what investors truly believe, so this isn't a very radical assumption.

Using CRSP data, and the standard 25 size-book/market Fama-French portfolios that are traditionally used for testing theory modifications, he uses monthly data generates mean 'alphas' for these

MSCI is very good at creating indices, and their Global Minimum Volatility Index is intriguing (BB ticker M00IWO$P). If I plot its return again a simple average of my Minimum Variance portfolios drawn from the UKX, NKY, MSER and SPX indices (UK, Japan, Europe, USA), they line up pretty well. Mean returns and standard deviations are basically identical over the period for which I have MSCI Global Minimum volatility data.

My index is created by taking all the constituents of these major indices each 6 months and applying an optimization algorithm that minimizes variance using the prior year's daily data. The solution defines a fixed set of weights over the next 6 months. MSCI weights things more globally, and has 8 different constraints. It seems if you simply want a worldwide minimum variance, the little constraints about industries etc don't matter much in risk/return effect. This highlights that

The Robeco low volatility team published their study of the low volatility effect in developing markets. David Blitz, Juan Pang and Pim van Vliet (2012) document the following:

In this paper we examine the empirical relation between risk and return in emerging equity markets and find that this relation is flat, or even negative. This is inconsistent with theoretical models such as the CAPM, which predict a positive relation, but consistent with the results of studies which have previously examined the empirical relation between risk and return in the U.S. and other developed equity markets.

This is important because while this effect has been well-documented in the developed countries, these are the first results for the BRICs and their ilk. The basic metric they used was to rank stocks by volatility, and create long-short portfolios based on the extremum quintiles. The result is a percent return number that

Noahpinion had a neat story on a paper by Harris, Jenkinson and Kaplan, which finds:

Average U.S. buyout fund performance has exceeded that of public markets for most vintages for a long period of time. The outperformance versus the S&P 500 averages 20% to 27% over the life of the fund and more than 3% per year. Average U.S. venture capital funds, on the other hand, outperformed public equities in the 1990s, but have underperformed public equities in the 2000s.

These strategies should have higher 'operational risk,' and thus higher risk from tail events, Knightian/Keynesian uncertainty. It highlights that merely noting an asset class is opaque and illiquid does not mean it generates an above-average return. This is especially important because many pension funds are stretching to alternative assets (read: hedge funds) under the illusion that these areas have less clear

A big question about low volatility outperformance is why it exists. Explanations range from the nature of geometric compounding, convexity in high beta stocks, some strange manifestation of risk, or the fact that investors prefer sexy stocks for lots of reasons (principle-agent problems, overconfidence, winners curse).

Now, the latter theories are most plausible to me, but they also require something else, because if a fraction of irrational investors buy something, that only affects equilibrium prices if other rational agents are constrained in some way (or, less plausibly, that everyone is irrational). Given most investors allocated only 50% or so of their liquid wealth to stocks, I find it implausible they are constrained in their equity allocations - they can invest more directly.

My explanation is that they look at their equity holdings relatively, and this makes risk symmetric: beta=0.5 has the same risk as beta=1.5. When this happens, deviating from

Looking at the SPX index, actual annualized volatility has been below 10 for the past couple months, which is very low historically. Funny you don't hear about Taleb or Spitznagel when vol crashes, only when it spikes (talk about a convex payoff!). See below for a chart.

The VIX futures, which are closely related, show that not only is the VIX spot relatively high, but the future volatilities are even higher. The slope of the futures curve is very high. As the VXX and TVIX are hedged via riding down the futures curve, this suggests above-average costs of using the VXX to hedge one's equity exposures.

Now, the betas formed by regressing against the SPX vs those formed against the VXX form an almost perfect linear relationship (this was done using 5-minute returns for 800 non-ETF stocks). Note the higher the SPX (aka regular) beta, the more negative the