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December 1, 2001

The Volatility Trap

By Kathryn M. Welling

Also in this article

  • The Volatility Trap

Louis Gave is a principal of Gaveco, a London-based independent investment strategy service formed a couple of years back by his senior partner and father. Not so remarkable, perhaps, except that Charles Gave, for all his fierce independence, has long been recognized as a leading - and original light in the world of European investment management.

A successful strategist who more than proved his mettle in big-time fund management, but who chafed at organizational strictures as much as at early retirement, Gave then went back to performing economic and asset allocation advisory services for select institutional clients a couple of years back. I caught up with Louis recently (Charles was touring Cambodia) for an update on the Gaveian world view.

Last time we talked, Louis, you were just undertaking a big study about the impact of hedge funds on the stock market-

I'm still putting the finishing touches on it. But here are just a couple of facts. Already, today, in Europe, 60 percent of commissions are generated by hedge funds.

More than half?

That's right. Even though, at the same time there are basically only 300-400 European stocks with enough volume for the hedge funds to trade. The implications are clear, in terms of concentration of ownership and also in terms of volatility. My work shows that the volatility of European large caps has been increasing massively over the past four or five years, while the volatility of the mid-caps and small-caps has actually been falling. And there's no reason to think that the impact has been any different in the U.S. Whether you look at the 300 or 500 largest-cap stocks in the U.S., or at the Dow Jones Industrial Average, volatility there has also been going up quite substantially since 1996, while volatility on the mid-caps and the small-caps has actually gone down. The question I ask is, since there's more volatility now in the big stocks than there is in small stocks, which is the exact opposite of the way it used to be in the early '90s, does this also mean that we should be seeing larger risk premiums attached to the big stocks now, much as they were attached to the smaller caps back then?

What's your answer?

It should. And if they do get a higher risk premium, that will present a problem for the bull market that we have been living, which has very much been a bull market of big cap stocks. And which, in a sort of virtuous circle, made possible a hugely active mergers and acquisitions market. A company like Cisco could buy another company every two weeks-

Because it could use its inflated currency-