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Adding a Model Validation section

Sunday, November 20th, 2011

We are working hard on adding a ‘model validation’ section … this is where users will be able to do an array of analytics on the risk indexes they built. The major issue we may see is that if the output doesnt demonstrate some phenomenal outcome: “wow, my US Equities risk index kept me out of all drawdowns and perfectly timed the bottoms in 2003 and 2009″ then the user would interpret the outcome confusing.

There are many ways to evaluate. Lets run through some we are considering just for ‘sanity checks’.

1) risk index positive / negative: For example, taking a look at average 1-month, 3-, 6-, 12- and 24- performance of the market index, then bifurcating the returns to when the risk index was in ‘high’ risk or ‘low’ risk territory.

2) risk index at an extreme: If the risk index hit a local high (say within the past 2-3 years), what was the market index’s subsequent returns. This was the main emphasis of Covert Analytics, as a ‘risk management software’ that would help align risk index peaks / extremes with market tops and bottoms.

3) regression and correlation of risk index level with subsequent market return: A little too academic, but worth a look

4) performance of risk index as a rebalancing indicator: here we can add a binary analysis, ie if market is in high risk territory, be in cash, or if in low risk territory be in the market. The major issue here is surely the risk index will cause the portfolio to be out of the market too long, thus missing out on many many months of compounding returns.

Oh the challenges. But this will be an invigorating part of the site, that will help quantify the usefulness of our approach and software for our users.

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What does Monti mean for the Markets?

Wednesday, November 16th, 2011

Speaking with top hedge fund managers, policy makers and bankers gives one a different perspective. We recently had the chance to discuss market views with a highly influential person in the European crisis. The view was that the “Italian crisis” was truly one of leadership – though that has been used all too frequently in recent months. This official believed that Italy, due to its massive wealth and deep capital markets, could survive the recent spike in borrowing costs and risk aversion. In other words, that it would not go down the path of Greece, Ireland and Portugal.

Then Berlusconi steps down, in comes Mr Monti. He is often called a technocrat. What is a technocrat? According to dictionary.com, it is defined as one who is a technical expert, especially one in a managerial or administrative position. Many ‘smart money’ managers we have spoken to recently have felt very passionately that Monti is without the support of the populace and that this will be another failed attempt by European policymakers.

Interestingly, today Mr Antonio Borges of the IMF (director of Europe) stepped down. Markets have sold off aggressively in the past week. Markets sold off pretty aggressively after the announcement.

Since October however, markets are largely unchanged with the S&P hovering between 1220 and 1280. This goes to show that markets are largely discounting very little from the day to day noise and widely fluctuating markets with no clear trend are very possible. It is for this reason that we adhere to our approach of sticking to the fundamentals, keeping an eye on sentiment and technicals, and letting the data speak for itself.

This is not a time for trading in and out of positions, but it is definitely a time when a tactical asset allocation is key.

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Is Buy and Hold Dead?

Tuesday, June 8th, 2010

 After reading a recent debate, I decided to chime in with my own thoughts on the matter. Somehow the discussion of buy and hold evoked the typical academic responses of markets being efficient and so forth.

A few comments on ‘efficiency’

Market efficiency implies that all information is assimilated into the current market price, and therefore there is no possibility that you can buy assets cheap, to then sell high, because if it was truly cheap, the market would quickly jump in to buy the security, thus bidding up the price, eliminating the opportunity. Fantastic, but is it logical? This is similar to the University of Chicago line of thinking that if there was a $20 bill on the floor, it must be fake because someone would have picked it up by now. We all know that there is a very high possibility that short term inefficiencies exist. The quant funds have all but proven it: DE Shaw, Medallion, AQR Capital are all funds that trade in liquid equity markets but arbitrage short term opportunities. A hedge fund expert wittingly referred to these funds as “excess liquidity providers”.  My favorite response to anyone who says that markets are efficient is: “that is a self fulfilling prophecy” …

The Buy and Hold Debate

Buy and Hold is an “asset allocation policy” … it basically implies that the strategic asset allocation it the best guess as to what will be the best performing allocation over the investment horizon (typically 1+ years). If you do not think buy and hold works, that means you adjust the strategic asset allocation (ie shift equity weightings up and down over time) and make tactical trades (short term opportunities that present themselves in the market) to add alpha.  Dynamic asset alllocation therefore, is saying that “buy and hold” doesnt work (ie “Buy and Hope” …. :-) .  Time varying asset allocation emphasizes that dynamically switching the asset allocation you can minimize the downside of bear markets, overweight markets that are rallying, etc. It is the holy grail of money management: “equity like returns with bond like risk”. 

Due to the increased difficulty in cranking out decent returns, it is even more important to “think dynamically”.

Performance of a 70% stocks, 30% bonds Portfolio

The chart below shows how difficult money management has been. A portfolio of 70% stocks and 30% bonds (note we are using the MSCI US Stocks Index, total return, for stocks, and the Salomon Brothers US Treasury Index, for bonds) performed as follows:

  • +16.6% per year from 1985-1999, with a standard deviation of 10.9%, compared with…
  • +1.8% per year from 2000-2010, with a standard deviation of 11.1% 

This is a huge drop in annualized values in an aggressive Equity portfolio (far below the risk free rate of return), with an elevated level of risk. The return to risk ratio was nearly 9x higher from 1985 – 19999 versus the past ten years.

Returns by Market (80s and 90s versus 2000s)

 

 There was a huge drop in asset class returns between the two periods. further strengthenting the case for a more dynamic approach to asset allocation in the 2000s. Even bonds have fared substantially worse in the past decade than the prior 15 years. 

Returns by Asset Class (80s and 90s versus 2000s)

Another asset class focused way to see the same data …

Efficient Frontier Comparison

This secular shift in returns between the different decades has produced a notable response to the buy and hold, academic oriented crowd: a notable downward push to the efficient frontier. Interpretations of the efficient frontier are as varied as how people like their eggs in the morning.  Some think it is useful, others useless, some think it is a good framework, others think it is a good tool for clients to see and not much else. Regardless, it is a mathematical approximation as to the “best, most efficient portfolios using return and covariance measures”.  Utilizing expected returns from these different periods, the following two, vastly different efficient frontiers were produced.

Conclusion

This is slicing the past thirty years into two periods, one when the business environment was booming and capital markets surged, and the other when the world suffered two disastrous bear markets and a global mini-Depression. Buy and Hold is a methodology that worked “before” and it is unlikely that it will work in the future.  After the carnage in 2008 and 2009, portfolio managers have lowered their expectations. With the world economy still unstable and risky, investors have accepted this fact, and our view is that asset allocation has to be more imaginative and dynamic.

 

 

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“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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Suggestion for CALPERS

Friday, March 19th, 2010

We agree with the Wall Street Journal article, implying that serious investors need to rethink asset allocation. It goes without saying that an asset allocation strategy “works” over the long run, but that doesnt help navigate through ferocious bear markets.

“In their research, managers came across Denmark’s ATP fund. In 2008, that $112 billion pension fund moved from allocating investments based on asset type to what drives risk, a spokesman confirms. For example, it put private and public equities into one category called corporate earnings, which usually perform badly during economic downturns.”

That is exactly how Covert Analytics suggests portfolio managers manage portfolios! Allocating investments based on what drives risk? That is the exact definition of what our platform is trying to achieve!!!

Suggestion: CALPERS can fire all their employees (except 2), hedge funds, advisors. Maintain one employee to manage their Covert Analytics subscription and other employee to execute trades! Problem solved.

Here is the link to the WSJ article

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Some need-to-know tidbits on market timing

Tuesday, March 2nd, 2010

We grew up in the ‘hood.  The “hood” of academic circles.  Our formative years in money management were spent surrounded by brilliant academics, a few literally with Nobel Prizes, a few more PhDs, and a bunch of graduates from Wharton / Kellogg etc.  This should be a great start, you would say? It actually wasn’t.

Quoting Warren …
In retrospect, we all learned a bunch. What I would sarcastically say is that we learned what not to think.  In our defense, even Warren Buffett said at his 2009 annual shareholders meeting that if he taught a course on investing, the first thing he would do is unteach the “efficient market hypothesis”!

Cross-Check
The problem was we were building a new type of money management firm, based more on index-investing (since you could not outperform the index) rather than blindly allocating to managers. The problem with that approach was still that you needed an asset allocation approach to “beat the business cycle”. The “Chicago boys” thought this was a waste of time, markets were efficient, you could not outsmart them, etc.  This greatly upset the other half of us, who wanted eventually to run our own hedge funds and were insulted at this death knell to our future careers.

Our focus has always been on using quantitative techniques to identify when investment opportunities offer the most probable profit. Thus why we developed Covert Analytics. We were frustrated that some basic tools were not commercially available for portfolio managers, money managers, investment management firms, asset allocators, family offices, whatever label you want to give them.

Fast forward to Covert Analytics
Our platform is not a market timing software.  Our software is about identifying when forces are in place to propel asset markets further, or when valuations, monetary conditions, etc are so stretched that a price collapse is likely in the medium term.

What the Research Says
We realize how important the confidence our clients place in us is. Our entire premise is that asset allocation is the most important decision a money manager has to make. More important than security selection, more important than the aggregate effect of tactical trades, etc. Here are some studies we recently evaluated and their conclusion on market timing.

  • The Clairvoyant Investor Not Much Better Off
    Sharpe (1975) imagined an investor who had two assets to choose from: US Stocks and Cash, and invested with perfect accuracy in the “higher returning asset” plus transaction costs.  The results were rather disappointing: Perfect Timing resulted in a 15.3% annual return versus 12.8% for Buy and Hold, an outperformance of 2.5% annually.  This did include however pretty high transaction costs.
  • Missing the 10 Best? Invest in Cash
    Jeffrey (1984) did an analysis on comparing perfect accuracy with horrible accuracy, but the most interesting conclusion we thought was this: If the 10 best performing stock market years out of his study are missed, then the resulting return is equivalent to a cash return.
  • Out for Best 7%, Return of 0%
    Chandy and Reichenstein (1993) came to a similar conclusion as Jeffrey: using monthly data since 1926, they concluded that if an investor missed the best 7% of monthly returns, then the remaining 93% of the months provide a 0% return.

Clearly market timing is  a tough task. We believe that with our approach, and a wide variety of assets, outperforming the market in a systematic way is achievable.  What this research proves is the following: forecasting bull markets is just as important (actually more important) than forecasting bear markets over the long run.

BTRheT

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