< The Finance Professionals' Post: September 2015

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7 posts from September 2015

09/17/2015

Decomposition of Total Volatility: How Important is Idiosyncratic Risk?

Introduction

In recent years there has been a lot of debate about volatility, and the components of volatility. A lot has been said about the risk-on, risk-off market with a focus on macro and factor risks. There are many dimensions to volatility, and this paper uses the methodology of Campbell et al. (2001) to break down the total volatility in US equities into the three components of Market, Industry and Firm (idiosyncratic risk), and analyzes the trends in their share over time. We look at the time period January 2005 through December 2014, incorporating the years prior to, during and post financial crisis, and use S&P 500 as a proxy for the US equities, with the Global Industry Classification Standard (GICs) sector classification. The main conclusion is that there is a strong payoff to stock selection even in the post-financial crisis era where market participants often think of risk only in terms of risk-on and risk-off. The share of idiosyncratic risk indicating benefits of stock selection decreased a lot during the crisis. It is now at the highest level since the start of the financial crisis, though still much lower than in the pre-crisis years.   

Active stock selection can make the greatest contribution when idiosyncratic risk becomes a bigger component of total volatility. Campbell et al. (2001) laid out some important reasons for decomposing aggregate volatility into its sub-components of market, industry and firm. Aggregate volatility, important in any theory of risk and return, is the volatility experienced by holders of aggregate index funds. But aggregate market return is only one component of an individual stock’s return, with industry-level and idiosyncratic firm-level shocks being two other important components. Some reasons to be interested in volatility of the sub-components include holding portfolios that may not be diversified enough, or arbitrageurs trading stock mispricings facing risks related to idiosyncratic volatility. The optimum number of portfolio holdings needed to make it well-diversified is itself a function of the level of idiosyncratic risk.

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Operational Due Diligence: The Forgotten Part of Due Diligence

FPPpicThe evaluation and selection of investment managers is dominated by an Investment Due Diligence process focused on strategy, performance, and client objectives. Often overlooked and considerably undervalued is the Operational Due Diligence process
which looks into the quality of a firm’s operations. As a necessary component of a complete due diligence process, it can be considered as the part of the process that confirms the validity of the findings resulting from investment due diligence. Comparatively, the operational process is more focused on the qualitative aspects of an investment firm and looks at areas such as people, processes, products, policy, and providers.

People

The overall objective of looking at the people who are employed within a firm is to verify whether their experience, qualifications and compensation are appropriate with respect to the portfolios managed, strategies employed and clients’ needs. Most investment firms can be broken down into three units: that is, a Front Office, a Middle Office and a Back Office.

Continue reading "Operational Due Diligence: The Forgotten Part of Due Diligence" »

Shocker! When you self-promote you actually help others

As a career coach, I work with clients who are top professionals in their fields. Despite their accomplishments and the desire to have more visibility in their careers, many struggle with self-promotion and self-advocacy. They come to me hoping to learn to articulate their value proposition and accomplishments to key stakeholders (i.e. managers, prospective employers, clients) without being perceived as boastful or bragging. 

The shocking thing is that most of my clients are confident individuals yet they get stuck when it comes to talking about themselves. Shying away from self-promotion prevents them from getting assigned to desirable projects, obtaining greater responsibility, and earning more money.

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09/03/2015

Book Review: Misbehaving- The Making of Behavioral Economics

MisbehavingRichard H. Thaler has spent his career studying the radical notion that the central agents in the economy are humans―predictable, error-prone individuals. Misbehaving is his arresting, frequently hilarious account of the struggle to bring an academic discipline back down to earth―and change the way we think about economics, ourselves, and our world. 

Traditional economics assumes rational actors. Early in his research, Thaler realized these Spock-like automatons were nothing like real people. Whether buying a clock radio, selling basketball tickets, or applying for a mortgage, we all succumb to biases and make decisions that deviate from the standards of rationality assumed by economists. In other words, we misbehave. More importantly, our misbehavior has serious consequences. Dismissed at first by economists as an amusing sideshow, the study of human miscalculations and their effects on markets now drives efforts to make better decisions in our lives, our businesses, and our governments.

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09/02/2015

Living in the Outlier

The past few years can only be described as one of the most unusually serene periods in history for the U.S. equity market. While over time it began to feel normal, we have been living in the outlier. Let’s take a quick trip down memory lane. 

The DiMaggio Streak of Markets

We’ll begin with the historic run from November 2012 through October 2014, what I have called the “DiMaggio streak of markets.” At 475 consecutive trading days above the 200-day moving average, we have never seen such a steady advance and lack of a meaningful pullback in the history of the S&P 500.

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7 Ways to Manage Writing by Committee

The best way to manage writing by committee? Avoid it. As Ann Handley says in Everybody Writes: Your Go-To Guide to Creating Ridiculously Good Content,

Having a buddy by your side is helpful. Having an entire committee on your back? Not so much. 

However, writing in a regulated industry means that many of you must get your materials reviewed by compliance. Also, if you’re a financial marketer, your subject-matter expert will want to check your work. 

I have some tips, based on my experience as director of investment communications for an asset management firm.

Continue reading "7 Ways to Manage Writing by Committee" »

Avoid Turning your Investment Firm into a Technology Company

Digits
As information technology’s development accelerated, the investment industry took notice and began developing systems that would automate formerly manual tasks. Over time these systems have evolved into something more. While their benefits are continually vaunted by vendors and end users alike, the processes of ensuring that these systems are properly implemented and maintained belong, first and foremost, to the firm.

It is easy to become seduced by the technological attraction
that systems offer but if an investment firm does not clearly
and thoroughly understand the purpose of a system, the
technological dream will quickly turn into a nightmare. In
general, systems are there to facilitate tasks, such as data
management, analysis and reporting. Once that is known, a
system must be properly “placed” within a firm. That is, it is to be maintained by the operations team, supported by IT, managed by specialists (performance, risk, etc.), used as a feedback tool by the front office and fund sponsors, and as a means of communications to the clients.

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