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Academic rains on weather/return correlation parade

29 May 2008

In our monthly column featuring the thoughts of a member of the Chartered Alternative Investment Analyst (CAIA) Association, we feature an active publisher in highly rated journals who has recently written an article on weather variables and their impact on financial markets. Wessel Marquering, Ph.D., CAIA, is quantitative researcher at the Talergroup.  Marquering and fellow researcher Ben Jacobson wrote an interesting paper on weather and financial markets for the Journal of Banking & Finance.  What follows are Marquering’s thoughts on the promise and peril of trying to extract alpha from the weather.

Alpha in the Weather: Alternative Viewpoints, powered by CAIA

Special to AllAboutAlpha.com by: Dr. Wessel Marquering, CAIA, Talergroup

As readers of this website are no doubt aware, weather derivatives trading is taking off - with trading volumes going through the roof and more hedge funds venturing into this space. Basically, a weather derivative is a financial product in which two parties agree to exchange cash flows determined by reference to a weather index. The reference indices include temperature, rainfall, wind speed, humidity, snowfall, to name a few, but the most heavily traded contracts are based on temperature indices.

On the one hand, weather derivatives can be used to manage risk, by insuring for example farmers against a bad crop, as an insurance against bad weather on holidays, by decreasing the exposure to temperature-related risk factors, etc. On the other hand, they have become a relatively new way to generate alpha.

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Converting the Sun’s Energy into Alpha

6 April 2008

After the huge interest in last week’s commentary by clean tech investor Investeco on alternative beta in alternative energy, we dispatched our intrepid “fly on the wall” (see his previous posting from London) to one of the biggest events on the clean tech investing calendar, the Wall Street Green Trading Summit.  We asked him to report back on any new markets that were ideally suited for an alpha-centric investor.  Here’s what he found…   

Dear Alpha Male,

(Thanks for the assignment on this side of the pond.  Much easier on the wings than the last gig.)

Anyone who thinks alpha is finite and non-renewable ought to check out the market inefficiencies the burgeoning clean tech sector.  According to the International Emission Trading Association, the international carbon market was worth approx. $70 Billion US in 2007  and according to New Carbon Finance the US market alone could equal $1 trillion by 2020.

Still, converting the sun’s energy in alpha isn’t like taking candy from a baby.  Such enormous growth might suggest that, in terms of generating alpha, low hanging fruit should be plentiful.  However, this was not the message to be taken from this gathering.  There may still be plenty of opportunities for generating alpha in emissions trading, but unless you’re exploiting opportunities in places like Russia and the Ukraine, you’re going to have to work harder to get it than ever before. The vast capital (intellectual and financial) getting into the sector has already eaten up the lowest hanging of the fruit.

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Alpha in Final Four tickets?

17 February 2008

After Duke’s absolutely crushing and embarrassing defeat of North Carolina earlier this month (okay, not quite “crushing“), we got to thinking about the upcoming US College Basketball championships (a.k.a. “March Madness”).  As TV commentators pointed out ad nauseam, every time Duke has beaten Carolina when Carolina was ranked in the top 5, Duke has gone on to the Final Four.  If only there was a way for us to get tickets to this event contingent on Duke actually being there. 

Turns out that there is now a service that let’s you do just that.  Yoonew is a start-up that has created a “free market” for tickets to events like the Final Four and Super Bowl.  By bizarre coincidence (or guided by the hand of God), Alpha Male learned about this firm at the O’Reilly Money:Tech conference in New York the day after the Duke/Carolina game . 

If you thought Steve Sapra’s application of the CAPM to NFL betting was interesting, you’ll like this story.  Yoonew has created a “options market” for sports tickets so you don’t have to wait to find out of your team actually makes it to big game.  Now you can buy an option on the ticket - to be executed only if your team is successful.  Of course, if your team chokes you are out your initial payment.  But the risk may be worth it though, since buying a ticket at game time could be many times more expensive that buying the futures contract right now.

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Sovereign Stealth Funds

3 February 2008

Sovereign wealth funds have operated quietly in the shadows for many years.  But all of a sudden, they have been thrust into the limelight - subjecting them to a force with which many have not yet had to contend: the media.

The website Breaking Views recently published a list of sovereign wealth funds ranked on the basis of “the potential risk they present to western interests”.  The criteria: transparency, control of strategic sectors, and “political threat”.

Apparently, many of these funds remain quite secretive.  In fact, some don’t even disclose their size.  So you’d be excused for wondering how these funds actually conduct investment research and make allocations.

AllAboutAlpha.com has learned from a reliable source that this secrecy extends well beyond fund statistics.  Representatives from one of the twenty funds listed by Breaking Views have apparently attended investment conferences using made-up company names.

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SocGen named “Equity Derivatives House of the Year”

25 January 2008

Earlier this month, Risk Magazine named venerable French bank Societe Generale as tops in its annual “Risk Awards“.  According to the magazine:

“With one of the largest exotics books on the Street, one would imagine that Société Générale Corporate and Investment Banking (SG CIB) would be licking its wounds and coping with hundreds of millions of euros in losses [after August’s market turmoil].”

A senior SocGen executive tells Risk about the importance of client relationships over short-term performance:

“We always quoted to clients and we were always present. For me, it was more important to be there for clients rather than worry about any mark-to-market losses on a few trading positions. Our reputational franchise is worth far more than any loss during one month,”

The article goes into detail about a myriad of “innovative” derivatives and structured products (volatility smiles, “CrossRoads”, structured products, vega-negative strategies…).  The question on everyone’s mind: Is this innovation the key to becoming the world’s hottest equity derivatives house?

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Davos Alpha

23 January 2008

[Dateline: Star Alliance business lounge at the Frankfurt Flughafen]  After a brief trip to address a private meeting of European asset managers, I now have the pleasure of spending 5+ hours at the Frankfurt Airport enjoying individually-wrapped cheese, mini croissants and a savory snack I can only describe as a sort of seasoned and glazed Corn Pops cereal.  (Traveller’s tip: With all due respect to the friendly folks at Lufthansa, I can’t really describe this lounge as the jewel in the Star Alliance crown.)

In any case, the television monitor behind me seems to be locked on the all-Davos channel.  As you may know - particularly if you watch CNN International or BBC World - the Annual Meeting of the World Economic Forum starts today in Davos, Switzerland, “the highest town in Europe“.  This is my first time in Europe during “Davos” since ending a decade-long stint working there as a part-time member of the small army that puts it together each winter.  It seems that during the ensuing years, the media hasn’t lost any interest in covering the CEOs, public figures, academics, movie stars, NGOs, religious leaders, media-types, and multi-lateral organizations that climb the “magic mountain” every year.

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Betting on the Super Bowl? Read this report on “NFL Alphas” first.

13 January 2008

Although it’s usually obfuscated by complex mathematics and applied only to world of investment management, “alpha” is a remarkably ubiquitous concept with applications that go well beyond the Capital Asset Pricing Model.   Steven Sapra, co-author of a recent paper on 130/30 (see related posting) provides us with proof of this.  Regular readers may recall his article about “NFL Alphas” posted on the Analytic Investors website last winter (see related posting).  Sapra has continued to research this topic and his latest conclusions are contained in an article to be published in the upcoming edition of the Journal of Sports Economics (a very cool-looking publication that AllAboutAlpha readers may find interesting).  The study is also available here.

The article goes by the unwieldy title “Evidence of Betting Market Intra-Season Efficiency and Inter-Season Over-reaction to Unexpected NFL Team Performance”, but can probably be summarized as simply “Don’t Fall for the Darlings”.  Sapra compares the expected results of over 4,000 regular season NFL games (based on the point spread) with the actual results of each match-up.  If the NFL wager market is perfectly efficient, the actual results should be randomly distributed around the predicted results.  In other words, a “fair” point spread means that the marginal bettor is ambivalent between taking either side of a bet - in the same way that the marginal investor should be ambivalent about paying the “fair” price for a security.

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Red Sox comebacks explained…

21 October 2007

We conclude our coverage of one of the leading stops on the hedge fund conference tour below.  This gathering of hedge funds and institutional investors (whose name we can’t mention because it’s a “no-media” event) is held in Boston each fall - around the time of baseball’s American League Championship Series (ALCS).  As New Englanders are aware, the Boston Red Sox are owned by John Henry, a noted hedge fund manager himself. 

Apparently, Henry and his team get some good vibes from all the hedgies in town.  Check out the ALCS results from Boston’s last two appearances (2004 vs. New York and 2007 vs. Cleveland).  Notice any patterns?   

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Alpha Generation in the NFL

11 February 2007

“NFL Alphas” 

Admittedly, alpha is a bit of an obsession for us at AllAboutAlpha.com.  We view alpha as the “magical”, un-replicatable, skill-based, value-add produced by human creativity.  In a world where nearly everything can be explained by systems, just about the only thing we can’t synthetically and cheaply replicate is human ingenuity.  In other words, what we can’t explain using known variables we chalk up to “alpha”.  This applies to financial markets, business, education, the arts, and even - as this article points out - to American football. 

Analytic Investors (see previous posting) calculates an “alpha” for NFL teams at the end of each season of American football.  They define this alpha as “the extent to which each team exceeded or underperformed its expectations”.  Essentially, they attempt to identify how well a team performed given the raw materials available to it.  While a comprehensive list of these raw materials isn’t listed anywhere, the “market” (i.e. bettors) collectively defines them via predicted margins of victory.  We might refer to this alpha - this unexplainable quality - as “heart” or perhaps “skill” displayed by the head coach in making the most with what he was given.

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Weekend Diversion: A Better Disclaimer

11 November 2006

For those of you looking to add more “teeth” to your usual investment disclaimer, we offer this one from a recent conference presentation:

“The opinions expressed in this presentation are not those of the speaker or anyone affiliated with the speaker. The speaker is making them up as he goes. The following presentation should not be assumed to be reliable, useful or even interesting. Any opinions expressed in the presentation are subject to change without notice – even during the presentation itself. Information presented herein is not guaranteed to be accurate, complete or in the ballpark. Any recommendations presented herein were derived from a rhesus monkey throwing darts at the stock listings page. Disagreement with the speaker is expressly forbidden – except where prohibited by law. The speaker may, at his sole discretion, use a “Chinese Wall” to ensure the audience is unable to throw anything at him. The speaker may or may not have an interest in the positions he advocates, and may not even be interested in them at all. Recipients of the presentation are asked to immediately forget anything they learned upon completion of said presentation. Parents are strongly cautioned. Do not attempt at home. Avoid contact with eyes.”

…which doesn’t seem that different from some of the other disclaimers we’ve seen recently.

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Alpha and Sailing

21 July 2006

By: Alpha Male 

This article (”Portable Alpha: Beta & Alpha, Both Important, Totally Different & Great Together“, July 2005) on combining non-correlated assets will resonate with sailors.  Ferrell and Podewils propose a method of analysing the benefits of diversification using vector analysis.  While they don’t specifically make reference to sailing, they use many of the same concepts.

“Risk vectors are a helpful tool in measuring Beta and Alpha risks and correlations.  The length of each line shows the amount of expected volatility. The angle created by the intersection of the two lines shows the correlation of their risks. If we observe the risk of a portfolio comprised of a combination of two perfectly correlated risks that are both long investments, the combined vectors are double the original volatility. Returns are also doubled, in both positive and negative directions.”

For sailors, one way of looking at Ferrell and Podewils’ approach is to view the volatility of the equity market as the wind direction where the length of the vector represents the annualized standard deviation of the market (e.g. S&P500) rather than the wind speed.  Let’s say the annualized standard deviation of the S&P500 was 20% and that your whole portfolio was made up of the S&P500 (e.g. via SPDRs).  Then let’s say you replaced half of your holdings with a fund that had a 1.0 correlation to the market.  Since the correlation is one, the volatilities would be purely additive and your overall portfolio volatility would remain 20%.  With a correlation of 1.0, you can never lower your volatility from 20%.  You are essentially on a “run” with the market.  This is illustrated in the chart at left.  (sailors: remember to flip the arrow directions to understand chart)  On a run, your complex and expensive sailboat is unable to add any value beyond a leaf being blown across the water. 

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