Archive for May, 2010

“Security Selection” within the Portfolio Management Process

Friday, May 28th, 2010

Talking to asset managers is always difficult. Yes you can have a great sense of their returns by looking at the myriad of stats available, (1-, 3-, and 5-year rolling returns, batting average, up- and down-capture, sharpe ratio, information ratio, to name a few) and you may even have a good qualitative assessment of the firm (their process, depth of their team, culture of the firm, etc). But to hear a manager pitch his fund is a grueling process.

You are always left wondering: how the hell can I assess whether the manager will outperform the market over the investment horizon (say a year or so). Does it even matter if the market is down 20% over the subsequent year?

Security selection is the part of the portfolio management process that is vital, and we historically were of the opinion that why complicate things? Throwing in a slew of more variables to analyze makes the process that more complicated. Let’s say conservatively when looking at 10 equity markets globally, along with 4 bond markets, plus commodities, you closely evaluate 5 indicators per market:

As you can imagine, this in and of itself is plenty of variables to

But now you throw in fund managers into the equation. Here is where it gets complicated. Client gives you, Advisor, the money, and you can either allocate directly to “markets” or invest in managers, that then invest in the markets.

Unfortunately we think there are so many negatives involved in this process, that it is never worth it. Let’s start with some key facts:

  • 75% of all funds underperform “the benchmark” net of fees
  • Clients pay you and then you are implicitly paying the manager *double layer of fees!*
  • Manager screening is another significant challenge for any advisory firm
  • Historical returns and wonderful pitchbooks are no indications of future returns

We think the model an investment advisor should proceed with is a combination of an asset manager (bottom up security selection + top down macro views) plus the investment advisor (matching capital market views to client-specific situations, ie portfolio allocations).

 

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Reminder on how to approach markets

Thursday, May 20th, 2010

Markets are sending clear signals …

 

Friday May 7 – day after Flash crash trade, SPX opens at 1126 and closes at 1,110

Monday May 10 – market opens at 1,160

Thursday May 13 – market trades at its intra-week high of 1,175, closes down 1.4% that day from the peak

Friday May 14 – market sells off again, with heavy selling pressure at the open

Monday May 17 – big selloff intraday with a huge recovery rally

Tuesday May 17 – the week’s bear market begins, with a strong open and a  decline of 2.5% that day …

Thursday May 19 – already down to 1,086 (almost at the “Flash Crash” lows). Market is down 7.5% since the peak on the 13th

Markets are in untested waters. I would like to give a great quote from Larry Hite, one of the premier systematic investors of our times:

“Two basic rules: 1) if you don’t bet, you can’t win, and 2) if you lose all your chips, you can’t bet.”

Keep that principle in mind. Why do we say untested waters? Because sovereign risk is an ugly situation for markets to face, because it isnt about corporate profitability, it isnt about market sentiment, it is about global macro panic. It is about the potential for a new global crisis …

Trade safely,

The Covert Analytics Team

 

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Keeping an eye on the indicators

Tuesday, May 18th, 2010

As we mentioned back here in our post on the direction of the stock market over the upcoming months, it is important to track the indicators.  Long story short, they have turned a bit ugly.  To paraphrase one of the true brightest and best:

“Put your ears to the railroad tracks. Prices move first, and fundamentals come second.”

This tells you that though reports are confirming that fundamentals are sound …

  • M&A, Capex, share buybacks, dividend increases have been running at historically low levels and are just beginning to rise
  • Corporates are lean, and richer in cash than they have been in decades
  • Profit margins are approaching all time highs, only a year after the “Great Recession”

… the market is sending a different signal:

  • Dr Copper and Dr Crude are both down about 17% (through today, May 18)
  • S&P was spooked into its largest intra day loss since 1987, and is now down about 7% from April 26
  • Yield curve (10s / 3Ms) has flattened by about 50 bps from nearly 380 bps to 330.

Where to from here? The Greek drama reflects a broader sovereign crisis that took us by surprise with respect to how quickly it cascaded into a crisis.  Greece was one of the weaker guys in the pack, but its amazing to us how Ireland has a deficit of -14.7%, compared with Greece’s deficit of -12.2% and little mention is made in the press of their situation. True, the total indebtedness of Greece is higher, at 124.9% of GDP compared with Ireland’s 82.9%.

And thats not all.  A massive oil spill, looming uncertainty over financial reform, civil lawsuits against the investment banks, etc.

Difficult times indeed. However we think the market is going to trade lower over the next few months. This is not to say the rally has been officially delayed, but these are major headwinds that have reminded the market that volatility is always around the corner. It is very easy to say that this has spooked a bunch of investors who have been cautiously adding to their exposure and are now reminded of the awful 2nd half of 2008.

Sincerely,

The Covert Analytics Team

 

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How we see ourselves …

Monday, May 17th, 2010

Covert Analytics is a different product. We hope that is obvious when you see our product for the first time, the ease by which our product gives you insightful results and analysis, and how our simple approach beats buy and hold and is the product you wish you had access to before the market crash! OK maybe not all those things, but we do hope it is a different product for you.

We cannot help but identify with another market leader, albeit in consumer electronics. And this is how we see ourselves:

Apple redefined consumer electronics, and we hope to redefine asset allocation. Our aim is not to be the most intelligent group of software developers and market practitioners, but instead the most easy to use product, that delivers the most benefits, and is one part of your business that is a stress reliever, and not a stress provider.

Sincerely,

The Covert Analytics Team

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The Importance of Covert Analytics to Your Firm

Monday, May 17th, 2010

As a dedicated software provider for the investment management industry, one of our top priorities is to educate. We do not educate to pitch our software but to educate the marketplace about our approach, which we think will definitively and sustainably improve any portfolio manager’s practice.

The recent black swans that have dominated the news have caused understandable fright among many investors and coinciding with that is a rise in apprehension among their money managers. Why is this? Because recent events are a reminder that the raging bull since March 2009 will finally be met with a formidable adversary: volatility. Vol is back. The past few weeks have brought about known risks: sovereign default risk, investor panic, wild currency swings and unknown risks such as the BP oil spill, Iceland’s volcanic ash, the US intra day market crash, etc.

There has never been a better time for an approach like ours. We think that the key differentiating factor of our software is that it was built by market practitioners, and not under the cozy umbrella of academia. A good analogy of this is being street smart versus books smart. Though the books smart guy may have the better degree and vocabulary, the one that is going to get you through the tough part of town safely is the street smart guy.

Covert Analytics is the streets smart guy. To borrow a saying from Eastern philosophy, “the best defense is a good offense”, and this is precisely what we aim to provide our clients. Our clients, again, are fancy hedge fund managers and simple fee based money managers in Ohio. The punchline we give potential clients is, for sure our market modelling is not the black box solution to solve your portfolio management process issues, but we are however a software that will help you (the money manager) sleep better at night.

The diagram below displays what we call the “Four Cornerstones of Portfolio Management” … as you will note we believe Covert Analytics touches each aspect of this four cornerstone approach.

 

1) Client Profile – this is set forth by our users when they specify the “focus” of the portfolio along with the target range. As you will note this is a no frills approach to “client specification” … as a bunch of other less relevant details can be included, however we think any advisor will agree these are the key questions to answer.

2) Asset Allocation – any user of our approach will benefit from the Covert Technique to asset allocation, by which markets are selected, quantitative risk indicators are built per market and a dynamic asset allocation (fully backtest-able) mode is constructed.

3) Security Selection – typically this would include a fund manager screening tool, however since our model allocates  to stock and bond markets along with commodity baskets, we would urge clients to view markets the same way. Top priority is picking the market and a distant second (on the priority list) is finding the vehicle.

4) Rebalancing & Monitoring – Covert Analytics emphasizes constant rebalancing as new data is incorporated into your model. The monitoring service allows you to keep a better eye on your models and the portfolios based on those models.

We hope you will see why we think our software is a great offense for any portfolio management, investment advisory or hedge fund shop. Please contact us if you have any questions.

Sincerely,

 

The Covert Analytics Team

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Important lessons for anyone running a business

Wednesday, May 12th, 2010

This is specific to the advertising agency, but great lessons all around.

http://adage.com/smallagency/post?article_id=143803

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Quantification Can Create the Illusion of Precision

Thursday, May 6th, 2010

At Covert Analytics our dynamic asset allocation models are based on risk indexes which portfolio managers build to evaluate the risk inherent in a market. But this quantitative indicator may create a false illusion as to the true risk of any market. Today was an example of this.

The past few weeks showed an amazing resurgence in seemingly black-swan type risks. First an Icelandic ash volcano that paralyzed European travel, a massive oil spill in the Gulf of Mexico, the “smartest guys in the room” aka Goldman Sachs getting hit with civil fraud charges by the S.E.C. and now out of nowhere a -9% selloff intraday on the US stock market. It was the biggest intraday selloff in percentage points since 1987.

Today showed us that financial markets are fickle. Sentiment and risk perception often swing abruptly. Greece’s economy is small, at EUR 254 billion, particularly in an economic bloc that is nearly EUR 9 trillion or 35x its size. The Greek problem has the potential to develop into a full blown epidemic, threatening the entire European economy.

The political tension is rising: elections in the UK today with a change in leadership from Labour to Conservatives, Germany’s elections in North Rhine – Westphalia, etc. A Greece bailout is very unpopular, but so is preempting a global financial crisis. Whereas some rumors have indicated that Greece has consulted with Lazard to examine a restructuring, other rumors have hinted at G-7 coordination today (May 7) to contain the crisis.

A simple punchline is that a Greek debt default or restructuring is inevitable. Even in the event of restructuring the result is the same.  Looking back to the 1930s the Creditanstalt bank default occurred in 1931, sparking a global banking crisis, but the great crash of the Great Depression occurred 2 years before in 1929.

Regardless on the view of whether Greece will be bailed out it is difficult to envision an environment where this will be beneficial for the Euro. This is not to say that a breakup of the EUR is in order. But, countries now including the ECB will be inclined to transition into quantitative easing, ie print their currencies.

Own gold as a hedge. Stocks are a good buy given that this event will definitely leave in place accommodative monetary policy. We dont think an all out default of Greece or a disintegration of the Euro bloc will occur. If we are right, stocks will rocket from current levels with renewed stimuli and a refocusing on economic fundamentals.

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