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Posts Tagged ‘Asset Allocation’

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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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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Stocks and the US$: Correlation Update

Tuesday, March 23rd, 2010
 

First lets review the formula. 

A correlation between two variables is the covariance between each divided by the product of each variables standard deviation (or the square root of each variables variance).

Since the correlation is a normalized number it is important to remember that it is a user friendly but not that usable variable. It describes the co-movement but says little more than that. There are much more powerful analytical co-dependence functions than correlation. Product advertisement: we are thinking about developing a powerful yet fun to use platform that will facilitate statistical modelling of financial markets.

Anyways, look at the recent rolling correlation of the S&P 500 and the US dollar.  This is a rolling 1 year correlation using weekly percent return figures on SPX and DXY.

S&P 500 and DXY Correlation: (Weekly, 1 year)

  1. Notice the very positive correlation leading up to the Tech bubble market peak in early 2000, where the correlation was as high as 60%.  Here the US economy was booming, the stock market was in a dizzying rally, and the US$ continued to strengthen (the EUR was at $0.85 in 2000, versus $1.35 now).
  2. The average correlation in this period was -20% as a strong dollar usually meant bad news for the US economy as it hurt exports, and correspondingly the market. Leading up to August 2008, the equity market was correcting and the equity market was selling off until September when Lehman went broke, and there was a massive flight to quality and the US$ rallied. This threw the market’s negative correlation back to nearly all time low of -60% until …
  3. From less correlated to slightly less correlated.  The correlation is increasing. We had a substantial bottom in the Dollar in December 2009 (since then the DXY is up nearly 8% and SPX is up about 6%).

It is important to mention that though the trade weighted Dollar is up 8% since early December, it is up almost 11% versus the EUR. This implies that versus other currencies the USD has not gained much.

Thanks for reading,

The Covert Analytics Team

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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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How we view market risk

Friday, January 8th, 2010

Risk is alot like rain, and your asset allocation is alot like an umbrella.  Your portfolio (you) always seem to get wet on your feet and the bottom part of your legs, right? Thats because the part of your body most exposed to the rain is your “risk assets” such as Equities and Commodities. These are the more volatile assets which though they have the best chance of giving your portfolio a substantial boost are also the most exposed when “the bear comes a-knocking”. The dry, upper part of your body? Thats the Bonds and Cash in your portfolio. Much more protected from the rain and thus less susceptible to market swings.

Risk and the Umbrella

 Covert Analytics aims to be your bigger umbrella! 

Covert Analytics = less risk

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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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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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