Liquidity Risk My ASS!

My buddy Roger Ehrenberg delivers the real goods in this post .

Best of all from the post:

And this reminds me of a quote from Bill Gross of Pimco in last Saturday’s New York Times:

“Our current system of levered finance and its related structures may be critically flawed,” said William H. Gross, the chief investment officer of Pimco, a mutual fund company. “Nothing within it allows for the hedging of liquidity risk, and that is the problem at the moment.”

Now I respect Bill Gross quite a bit and generally think he says some pretty intelligent stuff, but this doesn’t fall into that category. The problem isn’t with the system – it’s with the participants. You know how you hedge liquidity risk? By doing one of a few things:

Keeping excess cash on hand to cushion statistical anomalies in returns (at least what you might model as statistical anomalies);Diversifying the portfolio such that your asset classes don’t approach perfect correlation in market dislocations; andAvoiding too much leverage.

Now if the funds that melted down had followed at least one of these three rules, do you think they would have suffered the same fate? I think not. But if you want to fly high like Icarus, you run the risk of having your wings burned off. The problem is, you know who ends up holding the bag? Jeff Larson? No, his investors. This is why funds like Sowood managed $3 billion (run fast, run hot, put up numbers, get big, rake in fees and blow up – a classic negatively skewed/short option return profile), while guys like Nassim Taleb can’t raise much of anything (run like a turtle, hemmorage theta, bleed until the market craps out and then make a tidy sum – a classic positively skewed/long option return profile). There is no sexiness or appeal about losing most of the time and then winning big, as opposed to “winning” most of the time and then losing big. The issue is that most investors can’t get out when the usual winner is about to give it all back, while the principals of such funds still captured a large share of the spoils on the way up. It is what it is, I guess. I just find times like these instructive. If only managers and investors took instruction…

We need to try this tactic on new traders: