Risk-Neutral Vs. The Real World: Wall Street Traders Really Are From A Different Planet
Risk-neutral versus real-world pricing and valuations matter. Risk-neutral traders are less active, leading to trading and investment opportunities. Interest rates drive growth and inflation expectations, not the other way around. Traders at the big Wall Street banks have their own culture, language, idioms and superstitions. They have a peculiar code of ethics, ideals and standards of behavior. Indeed, they even have unique and privileged access to markets and information that both ordinary and sophisticated investors are envious of. It is like they come from and inhabit a different planet from the rest of us. It turns out the traders at the big banks do, in fact, belong to another world. Readers of a quantitative inclination will recall that sell side traders operate in what is called the Q, or “risk-neutral” world, whereas the buy side – that means the rest of us – function in the P, or “real world.” The distinction between the two worlds – the P and Q – is profound, and is also gaining increased importance. That is because the Q World, occupied by the traders at the sell-side banks, is under intense pressure to reduce risk taking activities. There is also a culling of Malthusian proportions going on at Wall Street trading desks, in effect depopulating the Q World. The table below describes the differences between the two worlds: The P World The Q World Goal Predict the future Extrapolate the past Environment Real world probability Risk Neutral probability Process Discrete time series Continuous time martingales Dimension Infinite Finite Tools Econometrics, statistics Ito calculus, SDEs Challenges Parameter estimation Calibration Business Buy Side Sell side Density ratio or ∏ =q/p should be a monotonically decreasing function of market returns. Source: Meucci 2011, CGA Research. The key point to note here is that sell-side traders, or the Q-World, do not really need to worry about future market returns. The sell-side model is based upon a cost-plus replication strategy that simply buys and sells securities at prices where risk is neutralized by various hedging strategies. As long as markets are reasonably complete and liquid, the sell side can isolate itself against future price developments. The sell side only gets into trouble when it moves away from the Q-World and risks its own capital speculating in the P-World. Now that we understand the two worlds, the question becomes what happens when Q-World goes away or its market power is greatly diminished? We have already seen and heard about disruptions and lack of liquidity in various bond markets since Q-World retrenched in the aftermath of the 2008 financial crisis. More recently, we see the effects in the oil markets where an unprecedented exodus from commodity markets by the big banks has contributed to the drastic fall in oil prices. Is it simply a coincidence that headline oil prices have declined by upwards of 50% during the same time that Morgan Stanley (NYSE: MS ), JPMorgan Chase (NYSE: JPM ), Credit Suisse (NYSE: CS ), Goldman Sachs (NYSE: GS ) and others have or are planning to exit the commodity trading business? Maybe, but it is more likely that a reduced number of Q-World commodity traders has facilitated the decline. In years past, large market declines were typically met by sell side traders bundling distressed assets into packages of securitized products that were ultimately on sold to buy side investors. The banks once had a stabilizing influence upon volatile markets. Such activity is no longer profitable for the banks due to stringent capital requirements and some outright prohibitions against warehousing the risk. Unwittingly or not, the world’s central banks, led, of course, by the U.S. Federal Reserve, have supplanted the diminished role of Q-World traders by providing an ample dose of extraordinary monetary accommodation. In other words, secular volatility is set to rise and will be further exacerbated once the world’s central banks move to the side-lines. Few people, including myself, expect the days of hyper activist central banking to end anytime soon. Nonetheless, at the margin, even the U.S. Federal Reserve is a little less active then last year. So what are the implications? Secular volatility will rise in most assets classes, particularly those that trade over the counter e.g. government and corporate bonds Market corrections will be more violent, happen quicker and take longer to reverse than in years past Intrinsic value does not change, although cash flow value may- which will ultimately lead to an abundance of market opportunities Specifically, there are now opportunities to buy the SPDR S&P Oil & Gas Explore & Production ETF (NYSEARCA: XOP ) after it fell 30% in 2014. The PowerShares DB Com Index Tracking ETF (NYSEARCA: DBC ), also off close to 30% in 2014, offers investors greater exposure to a basket of commodities, although the ETF maintains significant exposure to oil. Timing such purchases is always difficult, and the risk of being too early is real. My point here is that such declines have as much to do Q- World inactivity as they do with fundamental changes to the supply demand equilibrium. Hence, a good portion of the recent drop should prove to be transitory. Investment success rests with those that can best understand the phenomenon of markets explained by basic economic mechanisms such as supply and demand and, which can also incorporate agent based models of behavior. There is little doubt that such agent based models such as the need to save for retirement, risk aversion or the savings and consumption patterns of millennials to name just a few, account for a large portion of the variance of asset returns. What has changed recently is the agent based conduct of the Q-World traders rather than any fundamental principle of economics. That leads to opportunities for P-World investors like you and me. The trick is to balance your assessment of both Type I errors – investing in an unprofitable strategy and Type II errors – missing a truly profitable trading opportunity. The likelihood of making a Type II error has increased simply because there are fewer Q-World traders willing and able to take the other side of market overreactions such as the mid October 2014 equity selloff, materially wider U.S. High Yield spreads and the ever lower Euro currency. Looking ahead to 2015, I think it is important to note just how important it is to get your interest rate call right. Last year, Utilities (SPDR ETF, XLU ), REITs (iShares Dow Jones US Real Estate ETF, IYR ), and high-quality, long-duration government bonds (iShares Barclays 20+ Yr Treasury Bond ETF, TLT ) had total returns close to 25% to 30%. These three asset classes benefited enormously from lower nominal and real U.S. interest rates. With interest rates in play again in 2015 (higher or lower), the difference between Q and P world pricing and valuation becomes even more important. It used to be that investors just had to get the growth and inflation call right, and the interest rate view would simply follow. That no longer seems to be the case. It’s a big deal, and it’s a theme that I plan to develop further in a future newsletter. Look at it this way. U.S. growth and inflation readings in 2015 are likely to be quiet supportive of risky assets. Yet the market’s attention is almost wholly captured by a potential rise, however modest, of the Federal Funds rate.
