Friday, August 26, 2011

Easy Money (well, euros anyway)

Yesterday, European regulators extended the ban on short selling financial stocks in four countries: France, Italy, Spain, and Belgium. The ban was started on August 12 despite any highly unusual shorting activity up until that time. The ban was originally slated to run for 15 days, expiring today. The extension will run until 11/11/11 for France and September 30 for the other countries, barring any further extensions. While these actions will not stop the slide of European financials, they will highlight the incompetence of European financial regulators. The supposed leaders of the financial markets have thrown up their hands in dismay and cried “Uncle!” almost ensuring that markets will tank by undermining investor confidence. One does not often see a government signal to the world that it has no idea what to do about its economy. It is almost as if their plan is to place a “Please, don’t kick me.” sign on the back of their weakest members.

The Theory: Mechanics & Risks

The short sale bans do not work (the top chart shows the US ban from 8/08) mainly because the underlying company fundamentals (i.e. the value of the company) do not change, but also because today’s breadth of interconnected financial products makes it almost trivially easy to develop synthetic short positions. To create such a synthetic short one would look to build an arbitrage position but simply leave a hole where the banned security would otherwise fit in the portfolio. For example the most direct way to build a synthetic short here would be to short a European financials ETF and then use the proceeds to buy up the individual components, say German, Danish, and maybe Polish financials but not those from France, Italy, Spain or Belgium. The net effect is that one has a short exposure to securities that one is not technically allowed to short. The hitch is that everyone knows this and the European financials ETF becomes hard to borrow, driving up the costs.

Saturday, August 13, 2011

Finding Your Efficient Frontier

My friend and old colleague, Tom Anichini over at, has built a fantastic workbook for locating the tangent portfolio on an efficient frontier. Tom’s workbook is based on using up to 20 asset classes, which should be more than twice enough for most models. However it should also not be too difficult to adapt the matrix functions and arrays to whatever number you need. The beauty of the workbook is the use of matrix functions which makes the sheet fast and intuitive to use. It is an excellent example of just how powerful Excel can be when you know both how to use it and the math behind the finance.

To keep things fast, Tom abstracts away from returns forecasting and assumes a zero risk-free rate. The output is a series of portfolios broken down by expected volatility. Most investors typically treat the volatility of their portfolio as either a by-product of their investing, or, at best, as a secondary goal. That is if they pay attention to it at all. This is exactly the wrong way to think about structuring a portfolio. The risk component is every bit as important, and intimately tied to the return component.

Wednesday, August 10, 2011

Win $20k with XBRL

The Wharton Research Data Services (WRDS) and some partners are running a contest to see who can come up with the most inventive and useful application making use of XBRL. The prize is $20,000. The catch is the winning application must be open-sourced.

XBRL is the eXtensible Business Reporting Language: essentially an open meta-tag mark-up language for financials. Chairman Cox, when he was with the SEC, championed the use of XBRL to create the EDGAR database. A free database all publicly traded securities required data and an intuitive way to extract the data is a game changer for the investing industry. These advances vastly lower the barriers to entry for institutional quality analysis and should help improve price discovery and market efficiency over time. At least that is what should happen on the domestic side, hopefully someday international equivalents of EDGAR are not too far away.

Monday, August 8, 2011

This Time It's Different...

Around late 2000 or maybe 2001 I was sitting in a meeting listening to Richard Bernstein expound on his market sentiment indicator when he suggested I obtain a copy of Devil Take the Hindmost: A History of Financial Speculation by Edward Chancellor to gain a better understanding of bubble manias, particularly the Internet bubble of the time. Well, Mr. Bernstein must have made that suggestion to a lot of people because by the time I heard about it, this 1999 book was already extremely difficult to find anywhere. Ten years later, after more bubbles have risen and burst, I spent a sunny lunch break leisurely wandering through my favorite outdoor used book seller, when I finally chanced upon a copy of this elusive book. Seeing the price knocked down to just three dollars, I had to obtain it.

Chancellor takes the name of his book from an old expression that the Devil will get anybody who is too slow. So you better hurry up and not be last. Something akin to what we used to say, "last one there is a rotten egg." In a financial strategy that is knowingly built on the "greater fool" theory, being the last one to sell as an asset's price is rising will be your ruin, or as an anonymous pamphleteer warned against the South Sea Bubble, "the Devil take the hindmost."