In Osband's view, one of the strangest features of financial markets is their self-absorption. In the continuous experiment that is a trading session, the actors are also observers. Invoking Keynes, a financial market is not like a beauty contest aiming to pick out the greatest beauty, but it's aimed at finding out which contestant the other judges would pick as the best.
As each piece of new information comes in, including about the previous trade, market participants make adjustments in a never ending process, until the bell rings and the market closes.
When thinking about the CAPM formulation, the intrinsic value of an equity is like a port into which the market eventually puts in, through fundamental valuation and incorporation of all relevant information. In the weaker formulations, it may zigzag its way into port, overshooting and undershooting, but the ship puts in. In Osband's world, he models us away from the nice Gaussian distribution and takes us into beta and gamma distributions, where risk is not so neat and where uncertainty abounds. Volatility is high, trading volumes are high, and buy and hold strategies are not value producing.
He doesn't have kind words for pension consultants who focus on tracking error to evaluate mutual fund managers. Tracking errors, he shows, are good for fund managers' job security, but not for their clients. Conventional indexes contain most of the market risk and reward, so clients should be taking MORE risk on the residual element not less. His preferred model for a typical investor would be an index fund combined with a delevered hedge fund vehicle to produce superior returns.
Most mutual funds diversify TOO much given their investment profiles, where the benefits of risk reduction are quickly outweighed by mediocre holdings and inability to monitor the portfolio quality, which means defaulting to tracking error.
Talking about the melting of the global financial ice cap, he poses and answers the following questions:
- "Did we measure risk incorrectly?" Answer: Yes
- "Did we measure the wrong risk?" Answer: Yes
- Did we wrongly expect too much from our risk measures?" Answer: Yes
In my continuing search to understand what we really know about enterprise risk management, I found this comment particularly insightful: "Most risk managers have detailed knowledge of individual trade exposures, largely redundant with that of the traders they're checking on." What the risk manager doesn't know, both for model limitations and data limitations, are how these individual risks fit together. Given mark-to-market and Osband's model for market price behavior, the possibility of a nuclear portfolio event is never far away. As he writes, "Mankind can aspire to mastery of the universe but never achieve it. To err big is human."
He doesn't have kind things to say about US monetary and fiscal policies, and in particular the endless rolling over of public debt. We have seen the sovereign downgrade of US debt come and go. However, domestic sovereign default is the biggest risk facing the global system, Osband says.
Although he doesn't write about this, the second biggest risk is probably the slow unwinding or collapse of the Euro.
For state and local pension funds, his outlook is red on the Uncertainty Meter. We should "stop exempting public agencies from private sector standards for estimating the NPV of future (pension and bonding) obligations." Amen to that, and it's something that could be easily enacted although there might be casualties among the stampede of lobbyists in opposition.
And so it goes. Have a peek into Pandora's box with Osband.
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