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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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“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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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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Posted in Asset Allocation, Business Cycle, Dynamic Rebalancing, Our Approach, Stocks | No Comments »

The Covert Analytics Trinity

Saturday, January 30th, 2010

These are three integral components of the Covert Analytics approach, what we call our Trinity!

Here is a description of these components:

Gut feeling: We believe that the best money managers have a certain amount of experience, that translates into a “gut feeling” of the market. A deeper sense as to what drives the market’s up and down moves that does not vacillate depending on what the headlines say is causing markets to gyrate. It always amuses us when we see Bloomberg headlines that explain that “the market is up today because of X” and then subsequent day to see the market down and to have a headline that reads “X continues to disappoint, thus leading the market lower”. Gut feeling allows you to over write the noise. It allows you to have a grasp of what the market is going to do, how you will react if it unfolds and how you will manage your risk if it does not.

Systematic approach: This term refers to having a disciplined approach to investing, usually applied to ‘systematic hedge funds’. A systematic hedge fund is a concept that explains the investment style of the fund, where a system is in place to trade markets irregardless of the hedge fund manager’s input. The opposite of this is a discretionary approach, ie one where the hedge fund manager makes all investment calls for the fund on an “ad hoc basis”. We do not advocate that any investment advisor adopt a black box style approach to investing, which is what the majority of systematic hedge funds employ. What we strongly advocate however is that having a systematic approach which helps you maintain a framework across booms and busts, across bull markets and bear markets, will help you achieve greater returns over the long run by avoiding common pitfalls of investor emotions.

Global macro focus: Again this is a hedge fund term, but really applies more on the markets traded than anything else. The best global macro hedge fund managers (Paul Tudor Jones of Tudor Investment Corp, or Bruce Kovner of Caxton Associates) make the majority of their investment calls on broad market moves (ie where is the S&P going, how Crude, Gold is going to trade, where the Euro is headed) and typically abstain from “I like Dell over Microsoft” type calls. It is an emphasis on global capital flows and making money on stock, bond and commodity markets across the world. They benefit from the fact that usually “there is a bull market somewhere”. So not only is this a regional de-emphasis (ie go global), it is a security type definition as well (broad market indexes).

Covert Analytics is a software platform that was developed to allow investment advisors combine these three key paradigms into one successful money management platform. Our asset allocation software was designed to allow you to combine your gut feeling, with a systematic approach (that you custom tailor), and to have a global macro focus (rather than just simply allocating to US stocks, US bonds, and Cash).

The Covert Analytics Team

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Great quote from a NY hedgie

Wednesday, January 20th, 2010
Was speaking to a NY based event driven hedge fund manager yesterday, and he had a great quote:

“Investing is 70% instinct, and 30% homework”

This is no small time hedgie either. He is the founding partner of a $2 billion event driven hedge fund. Reminds us of a great quote from one of our favorite investors, Marc Faber:

“Investing has a lot to do with common sense and personal observations”

We built Covert Analytics to allow investment advisors and portfolio managers to input their views across global capital markets. The framework we initially conceptualized would allow investors to apply a logical methodology to evaluate a varied group of assets, and to see how this methodology would have worked historically.

Here is how we see our platform “mixing” with our great quote:

Your views, our platform

Covert Analytics is a platform, that combined with your views, produces information that helps drive your portfolio management process

Our plaftorm + Your Views = Input for your PM Process

Our platform is not a black box which tells you how to allocate. Our software allows you to input market specific views without the traditional academic mumbo jumbo of forecasting market returns or standard deviations, but instead allows you to build and combine indicators which are consistent with your views. Our proprietary backtest methodology allows you to evaluate how your asset allocation model performs historically, factoring in the portfolio guidelines you set forth, and proposes a recommended asset allocation.

Covert Analytics is a platform which allows you to build dynamic, quantitative asset allocation models that are driven by your expertise, and your views. We are glad our hedgie friend said that, because we could not have agreed more!

The Covert Analytics Team

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Start asking the right questions

Friday, January 15th, 2010

As an investment advisor you are primarily responsible for 1) having a view on the markets and 2) how to position your portfolios (given their unique constraints) according to those views.  Too often more attention is paid to the vehicles used to implement those decisions. In other words, rather than spending the bulk of your time deciding how much to allocate to Equities, you spend the bulk of your time picking Equity fund managers.

The article below is a perfect example of this.  Though it is a good article, from the Financial Times Fund Management section, it should not be groundbreaking news to investment advisors. It should be met with a shrug of the shoulders.

The wrong question still has a good answer!

Too often outperforming Equity managers still cost portfolios to suffer substantial drawdowns in a bear market. Too often the best bond fund outperforms its benchmark by 300 bps annually during a market cycle that saw Equities double.  You see where this is going? Start asking the right questions:

In general, here is our view …

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BCA on the business cycle

Wednesday, January 6th, 2010

BCA is one of the great research houses in the world.  They are usually spot on and great at separating the hysteria from reality and translating noise into signals to drive investment decisions.  They recently have made interesting parallels between historically sharp recessions and the corresponding vigorous recovery in Equity markets. In other words the sharper the drawdown in the economy, the fiercer the recovery rally when it comes. 

Here they differentiate between a normal economic cycle downturn and one associated with a financial crisis.  Their conclusions indicate that they believe that this will not be a V shaped recovery.  One of our previous posts pointed to the fact that “bad news is good news” in that bad news (or news confirming a weak recovery) is good for asset markets because it implies that the governments will be there eager to provide liquidity and stimuli. 

BCA: Financial crisis recoveries (red) vs Normal

From BCA:

Economic cycles associated with financial traumas such as banking crises or asset price collapses tend to have deeper downturns and weaker upturns. The current uptrend in U.S. economic growth should be sustained, but the rebound will remain subdued compared to recent recoveries.

In the past, there has been a close correlation between the severity of downturns and the vigor of subsequent recoveries, arguing that a V-shaped expansion in the U.S.  may be in order. In this context, the consensus forecast of 3% growth in U.S. GDP in 2010 seems low relative to past cycles. For example, the economy grew at an average 7.7% annualized pace over the six quarters that followed the deep 1981-82 recession. Optimists also note that the slope of the yield curve historically has been a good indicator of the economic cycle. Thus, the current steep yield curve in the major economies would be another reason to expect a vigorous economic expansion. However, the lingering after-effect of the financial bust will remain a serious headwind to growth in much of the developed world for the next few years. Indeed, recoveries that follow financial recessions tend to be much weaker than what follows non-financial recessions. Significant damage was done to the financial infrastructure in the past year, consistent with a weaker-than-normal economic expansion. Bottom line: While the global economic recession has ended, growth in the major developed regions will be slower than would normally occur after such a deep recession. This should limit consumer price pressures and keep policy conditions constructive for risk assets.

 Hope you enjoy the read,

The Covert Analytics Team

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Trends in the Investment Management Industry: ETFs

Tuesday, January 5th, 2010
This graph is a depiction of how the investment management industry has evolved since the 1980s. Whats most obvious is that the dominance held by traditional funds (ie mutual funds) is being replaced by the index funds or passive investment approach.  Also note the growing importance of alternatives.  By alternatives we mean the alternative invesmtment management industry (specifically hedge funds, private equity etc).  Under index funds we lump the growing asset classes devoted to commodities (including Crude, Gold, Silver, Agriculturals, etc).

Evolution of the Asset Management Industry

We think most investment advisors should abandon the desire to bringing the “best” in the investment management industry into their client portfolios.  Time after time, we have seen mutual fund managers with stellar “alpha” capability get destroyed on a absolute and relative basis (Bill Miller of Legg Mason and Richard Pzena of the Pzena Value Fund are some examples).  What about hedge funds? They never do any harm right? Wrong.  Forgetting for a moment the obvious disasters like Madoff, there have been a string of “high-flying, hot shot” hedge fund managers that blew up rather spectacularly. 

Some “meltdowns” to note of in the hedge fund world: Polygon Global, Platinum Grove, and Amaranth … which were forced to wind down after horrendous performance. A slew of other hedge fund disasters are “restructuring” their funds, something which to me sounds like changing around the terms so they can start charging egregious performance fees given they are years away from hitting their old “high water marks”. 

Regardless, the range of investment options via low cost index funds is growing at a steady rate. For those eager to implement asset allocation strategies across various stages of the business cycle, futures or index funds are the way to go.

The Covert Analytics Team

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What is investing?

Monday, January 4th, 2010

Here is our take on investing (borrowed from an analogy of Mr. Buffett): laying out cash in the present to get more cash in the future.

Diagram of What Investing Means

Aesop explained a relevant principle in one of his famous fables:

Aesop's Fable

Aesop was saying that it is better to have a sure thing than take a major gamble. Applying this concept to investing:

Aesop's Theory on Investing

Investing is trading the bird in the hand today for more birds in the future. There are many questions to ask including how many birds are in the bush, how sure you are to catch them, when you will catch them and how many birds there are in other bushes.

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Understanding the concept of risk indexes

Monday, December 28th, 2009

When attempting to explain our approach to clients, we like to revert to simple to understand examples.  Our whole approach builds on “risk indexes” created per market. The markets we focus on – and to which our dynamic asset allocation methodology allocates – is to the major global stock and bond markets, as well as Commodities. To each of these markets we focus on creating risk indexes which identify not when markets are a “good buy” or a “strong sell” but instead attempt to identifywhat the major structural forces that impact asset markets are saying. 

It is similar to the temperature gauge in your car. When driving, you want to see the temperature gauge ”right in the middle”. In other words, not too hot and not too cold.

Our risk indexes function in a similar way. The combination of indexes create cyclical indexes which evaluate when markets are “high risk”, “low risk” or in “equilibrium”.

“Right in the middle” for our indexes would describe an equilibrium state. A high risk index reading (essentialy a combination of indicators that are 1 standard deviation or more away from their mean) implies that markets are “at risk” of a correction. The size of the correction is determind by how “high octane” the market is of course.  A high risk index reading for US bonds would imply a much smaller correction than a high risk index reading for US stocks.  A low risk index reading implies that structural forces are pointing to a positive environment for the market. In other words, the market is a “low risk buy”.  This does not imply that markets are immediately ripe for a bull market, but it does imply that the combination of indicators selected point to substantially higher market values from the current readings.

We hope you enjoy reading our blog. Please note: Our web application is set to be launched towards the final weeks of January. We are currently in the final stages of development. Our platform will be an invaluable tool for any portfolio manager and we are so excited that you are a part of it.

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