Liquidity and lottery tickets

THOSE who occasionally bet on horse races like the Kentucky Derby or the Grand National have a tendency to favour 100-1 outsiders. Their motivation may be the desire for a big win to justify the act of gambling at all.

The same tendency to overpay appears in the sophisticated world of financial markets. High-volatility securities within each asset class, such as CCC-rated corporate bonds or 30-year Treasury bonds, tend to offer lower long-run returns than other assets in their category. This goes against the grain of financial theory, which states that investors ought to demand higher long-term returns for owning more volatile securities.

It seems, however, that investors are hoping to get “more bang for the buck” by buying these assets, just as punters buy more lottery tickets when the payout is known to be large. A related tendency is for investors to overpay for shares in fast-growing companies, wrongly assuming that such growth rates can be maintained over the long term. Everyone wants to find the next Apple.

If the past three years show anything, it is that markets do not work as the models suggest. Antti Ilmanen, a hedge-fund manager at Brevan Howard, outlines many of the anomalies in his epic book*, “Expected Returns: An Investor's Guide to Harvesting Market Rewards”.

The Treasury-bond market provides another case study. The trade-off between return and risk improves rapidly as investors buy assets with longer-term maturities, but only up to two-year bonds. After that it flattens out.

The reason may be that investors desire liquidity, defined in this case as assets they can sell easily and for which they can realise close to full value. In particular they like assets that retain such characteristics when other markets are going to hell. That makes them prefer very short-term Treasury bills with maturities of a month or less. Such demand drives down the yield (and return) on those assets and creates an opportunity for investors able to take a longer-term view.

In a sense, this liquidity preference can be seen as the obverse of the lottery-ticket tendency: investors overpay for both low-volatility and high-volatility assets.

Some anomalies can be explained by variations of both phenomena. Take the carry trade, a strategy oft-cited by investment pundits to explain market activity. Investors borrow money in a low-yielding currency, such as the Japanese yen, and invest in a higher-yielding currency, like the Australian dollar.

The carry trade is a bit of a puzzle since it seems too simple to work. You would expect currency investors to demand a higher yield as compensation for the risk of depreciation. Countries with high interest rates are normally those with high inflation rates and you would think such currencies would lose value over time.

But the carry trade has been persistently profitable for around 30 years. On average, investors have pocketed the higher yield without suffering any effects from depreciation.

Why has it worked? Mr Ilmanen argues that a carry-trade strategy is akin to the actions of the seller, rather than the buyer, of lottery tickets. In most circumstances, the strategy appears to be profitable but then, on a few occasions, the numbers turn out badly.

The strategy can fail in two different ways, reflecting the two legs of the trade. In the first the investing currency devalues massively, as happened in Iceland in 2008. In the second, the funding currency rises sharply. This tends to happen at moments of general panic, as investors attempt to reduce their leverage. In order to cut their borrowings, they have to buy the low-yielding currency that was borrowed to finance the trade. This causes that currency to rise.

As a result, a carry trade tends to go wrong at the moment when most other risky assets (equities, high-yield corporate bonds) are also suffering. It thus has the opposite characteristics to the short-term Treasury bill. As a result, Mr Ilmanen conjectures, investors demand a higher return as compensation for the risk they are taking on.

The lottery/liquidity trade-off creates opportunities for profits elsewhere. In corporate bonds the best returns have been achieved not from the best credits or the worst, but from companies rated BB, just below investment grade. There are many more thought-provoking examples in Mr Ilmanen's insightful and wonderfully lucid book.

* Published by Wiley. 570pp £45/$75

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