Lies of Capital Lines

In this paper we examine in detail the qualitative effects caused by the investors sensitivity to mark-to-market and price of liquidity. This distorts CAPM-like portfolio construction causing the Capital Line to become curved and eventually inverted. We show that in the world of strongly concave and non-monotonous Capital Lines, pushing up return targets results in increasing risk but not in increasing return. This is due to the decreasing and eventually negative marginal returns per unit of risk. By chasing returns and prompting investment managers to deliver unsustainable performance, the investment community damages its own chances through a greedy search for yield. Besides negatively skewing the risk-return characteristics, this also amplifies destabilizing pro-cyclical dynamics and increases the component of volatility, which is not accompanied by corresponding return. The latter has profound consequences for investment management and economic policy making. We examine the influence of non-linearity of the Capital Line on the cyclical volatility of capital market and short optionality ("negative gamma") profile, implicitly embedded in classical investment approach. We show how to mitigate this negative effect by including long volatility funds in the investment portfolio. We also discuss adverse selection bias among investment managers, created by the investors demand for high unsustainable returns. Since one can only hope that the behaviour of either capital allocators or investment managers will change, we argue that it is left up to regulators to take measures to limit the use of credit and leverage, and to control the self-enforcing mechanism of market destabilization.