Team Hedge Fund

Archive for the ‘Hedge Fund’ Category

Correlation? Assets moving in synchrony? Correlation is a misleading statistic of little help in measuring or achieving diversification. Highly correlated funds CAN hedge a portfolio but some uncorrelated strategies are too dependent on underlying markets. Below is a hypothetical hedge fund with +1.00 correlation to the S&P500. Absolute returns every year and +17.65% CAGR but correlated PERFECTLY with a risky index fund which lost money! Clearly the product diversified despite that pesky correlation.

Diversification was said to be a “free lunch” but that has been arbitraged away, at least in traditional risky asset classes. 2008 showed how important it is to diversify the right way not diworsify the old way. Sadly correlation is still used as a critical input for portfolio construction and risk management. During crashes, correlations tend to rise but now it occurs in “normal” market conditions as well, adding to risk NOT reducing it. Securities can move together due to herding, ETFs and algorithmic trading. The passive indexing meme means benchmark components go up or down regardless of value whether they are stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long.

The omnipotent correlation matrix drives much portfolio “optimization”. A bunch of incorrect inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On up market days most stocks may go up but they don’t rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don’t mind if an investment has a correlation of +1, 0, -1 or anything in between. It’s irrelevant. I do care it has minimal dependence on anything else in the portfolio. Sadly for traditional investors MVO and CAPM have been shown to be simple, elegant and completely useless.

“Modern” portfolio theory requires three sets of wild guesses marketed as capital market assumptions: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor “results” speak for themselves. Those variables aren’t robust, stable or likely to be accurate in constructing a long term portfolio. I’ve kept track of such facile forecasts and the tea leaf reading “experts” who made them. Pretty sad outcomes but those fortune teller numbers still keep being used. We are ALL affected by assets being (mis)allocated in this failed framework. Unlike the crystal ball gazers I don’t try to predict markets instead I find mispriced securities and safer strategies whose returns outweigh risks.

It is not surprising conventional wisdom has performed so badly with “Nobel” prizes awarded for such “efficient”, mean variance “optimized”, CAPM nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random right? CMA causes almost as many problems as actuarial assumptions. If you keep doing what you have always done, you receive what you always get: growing liabilities and declining assets! Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.

Beta is usually cited as a measure of volatility. But it’s really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta fund that is high risk and a high beta security LESS risky than the market. Idiosyncratic risk isn’t a risk; it’s the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is more complicated. I prefer calculating co-relation and association metrics not coRRelations. High correlation shows the markets are even more inefficient.

Dispersion? Every month reports come out on how “hedge funds” have performed on average. Those numbers are meaningless with such a disparity of skills and zero-sum nature of alpha. Most of the mainstream strategies are too well-known now so it is not surprising AGGREGATE returns are tending to zero. Skill is rare. The average hides a wide range of numbers from managers performing very well to many that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of covariances and variances just don’t make the grade.

The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don’t allocate to such a reliable source of alpha. Last decade was great and returns have also been good this “difficult” year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors avoid high frequency strategies. Perhaps buy and hold for a few milliseconds is the natural evolution from buy and hold for a few decades. Everything operates on short time horizons nowadays.  If you want to learn more about hedge fund companies, how they operate and more information, check out this website.

There is a big difference between good funds and bad ones. Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term “emerging markets” is often semantic arbitrage for countries that are actually developed. The old BRIC lost to the new BRIC but the SLIM has been the rockstar this year. Sri Lanka, Iran, Mongolia were missed by almost all international investment “strategists”. Could the geographic diversification strategy nowadays be to invest in places that do NOT have ETFs? It’s an Asian century but not in the most heavily hyped markets.

Unlike the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver in all possible scenarios over time. Changing markets and rising correlationare no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important. Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on the market and focus on skill-based absolute return strategies.

by Veryan Allen. Copyright

Go to Source

Correlation? More assets moving in synchrony? Correlation is a misleading statistic of little help in measuring or achieving diversification. Highly correlated funds CAN hedge a portfolio but some uncorrelated strategies are too dependent on underlying markets. Below is a hypothetical hedge fund with +1.00 correlation to the S&P500. Absolute returns every year and +17.65% CAGR but correlated PERFECTLY with a risky index fund which lost money! Clearly the product offered diversification despite that pesky correlation.

Diversification was said to be the only “free lunch” but that has been arbitraged away, at least in traditional risky asset classes. 2008 showed how important it is to diversify the right way not diworsify the old way. Sadly correlation is still used as a critical input for portfolio construction and risk management. During crashes, correlations tend to rise but now it occurs in “normal” market conditions as well, adding to risk NOT reducing it. Securities can move in sync due to herding, ETFs and algorithmic trading. The passive indexing mania means benchmark components go up or down regardless of value whether they are stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long.

The omnipotent correlation matrix drives much portfolio “optimization”. A bunch of incorrect inputs from data dredging history whose forward-looking output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On up market days most stocks may go up but they don’t rise by the same percentage. Relative value strategies take advantage of varying price moves even if in the same direction. I don’t mind if an investment has a correlation of +1, 0, -1 or anything in between. It’s irrelevant. I do care it has minimal dependence on anything else in the portfolio. Sadly for traditional investors MVO and CAPM have been shown to be simple, elegant and completely useless.

“Modern” portfolio theory requires three sets of wild guesses marketed as capital market assumptions: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this weird way and the poor “results” speak for themselves. Those variables aren’t robust, stable or likely to be accurate in constructing a long term portfolio. I’ve kept track of such facile forecasts and the tea leaf reading “experts” who made them. Pretty sad outcomes but those fortune teller numbers still keep being used. We are ALL affected by assets being (mis)allocated in this failed framework. Unlike the crystal ball gazers I don’t try to predict markets so I find mispriced securities INSTEAD and safer strategies whose returns outweigh risks.

It is not surprising conventional wisdom has performed so badly with “Nobel” prizes awarded for such “efficient”, mean variance “optimized”, CAPM nonsense. Past asset class returns are no indication of the future over any time horizon including centuries, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random right? CMA causes almost as many problems as actuarial assumptions. If you keep doing what you have always done, you receive what you always get: growing liabilities and declining assets! Safer to go with skill-based strategies that offer absolute alpha not repackaged beta.

Beta is usually cited as a measure of volatility. But it’s really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta fund that is high risk and a high beta security LESS risky than the market. Idiosyncratic risk isn’t a risk; it’s the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is more complicated. I prefer calculating co-relation and association metrics not coRRelations. High correlation shows the markets are even more inefficient.

Dispersion? Every month reports come out on how “hedge funds” have performed on average. Those numbers are meaningless with such a disparity of skills and zero-sum nature of alpha. Most of the mainstream strategies are too well-known now so it is not surprising AGGREGATE returns are tending to zero. Skill is rare. The average hides a wide range of numbers from managers performing very well to many that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The basic arithmetic of covariances and variances just don’t make the grade.

The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don’t allocate to such a reliable source of alpha. Last decade was great and returns have also been good this “difficult” year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors avoid high frequency strategies. Perhaps buy and hold for a few milliseconds is the natural evolution from buy and hold for a few decades. Everything operates on short time horizons nowadays.

There is a big difference between good funds and bad ones. Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term “emerging markets” is often semantic arbitrage for countries that are actually developed. The old BRIC lost to the new BRIC but the SLIM has been the rockstar this year. Sri Lanka, Iran, Mongolia were missed by almost all international investment “strategists”. Could the geographic diversification strategy nowadays be to invest in places that do NOT have ETFs? It’s an Asian century but not in the most heavily hyped markets.

Unlike the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver in all possible scenarios over time. Changing markets and rising correlation are no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important. Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on the market and focus on skill-based absolute return strategies.

by Veryan Allen. Copyright

Go to Source

Correlation? More assets moving together? Correlation is a misleading statistic of no help in measuring or achieving diversification. Highly correlated funds CAN hedge a portfolio whereas some uncorrelated strategies are too dependent on underlying markets. Below is a hypothetical hedge fund with +1.00 correlation to the S&P500. Absolute returns every year and +17.65% CAGR but correlated PERFECTLY with a risky index fund that lost money! Obviously the product offered diversification despite the correlation.

Diversification is said to be the only free lunch but that has been arbitraged away, at least in traditional risky asset classes. 2008 showed how important it is to diversify the right way not the old way. Correlation is wrongly used as a critical input for portfolio construction and risk management. During crashes, correlations tend to rise but now it occurs in “normal” market conditions as well. Securities may move more in sync due to herding, ETFs and algorithmic trading. The passive mania means many benchmark components go up or down regardless of value whether they are stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long. And with skill-based strategies that offer absolute alpha not repackaged beta.

Beta is usually cited as a measure of volatility. But it’s really correlation adjusted for the relative volatilities of the fund and benchmark. You can have a low beta fund that is high risk and a high beta fund less risky than the market. Idiosyncratic risk isn’t a risk; it’s the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is more complicated. I prefer calculating co-relation and association metrics not coRRelations.

The all powerful correlation matrix drives most portfolio “optimization”. A bunch of incorrect inputs data dredged from history whose output is even more error prone. Garbage in, garbage squared out. Correlation is a bad measure of magnitude. On up market days most stocks may go up but they don’t rise by the same percentage. Relative value strategies take advantage of different security price gains even if in the same direction. I don’t mind if an investment has a correlation of 1, 0, -1 or anything in between. It’s irrelevant. I do care that it has minimal dependence on anything else in the portfolio. Sadly for investors MVO and CAPM have proved simple, elegant and completely useless.

“Modern” portfolio theory requires three sets of wild guesses called capital market assumptions: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in such a weird way and the poor “results” speak for themselves. Those variables aren’t robust, stable or likely to be accurate in constructing a long term portfolio. I’ve kept comprehensive records of these facile forecasts from 2000 and the experts who made them. Pretty sad reading but these absurd assumptions still keep being made. We are ALL affected by capital being (mis)allocated by this method.

It is not surprising conventional wisdom has performed so badly with Nobel prizes awarded for such “efficient”, mean variance “optimized”, CAPM nonsense. Past asset class returns are no indication of the future over any time horizon, standard deviation does not measure risk and correlation gives no insight on risk factor dependence. So why is this stuff still used? Everybody knows everything so the markets are random right? CMA causes almost as many problems as actuarial assumptions. If you keep doing what you have always done, you receive what you always get: growing liabilities and declining assets!

Dispersion? Every month reports come out on how “hedge funds” have performed on average. Those numbers are meaningless with such a disparity of skills. Most of the mainstream strategies are too well-known now so it is not surprising AGGREGATE returns are tending to zero. Skill is rare. The average hides a wide range of numbers from managers performing very well to many that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to isolate manager skill from luck. The elementary school basic arithmetic of covariances and variances just doesn’t make the grade.

The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how the majority of portfolios still don’t allocate to such a reliable source of alpha. Last decade was great and returns have also been good this “difficult” year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors avoid high frequency strategies. Perhaps buy and hold for a few milliseconds is the natural evolution from buy and hold for a few decades. Everything operates on short time horizons nowadays. Amazingly no 401(k) offers HFT funds as a menu option! Widows and orphans need consistent returns too.

There is a big difference between good funds and bad ones. Emerging markets have also had high dispersion with frontier markets tending to outperform. Frontiers are less dependent on the world economy while the term “emerging markets” is often semantic arbitrage for countries that are actually developed. The old BRIC lost to the new BRIC but the SLIM has been the rockstar this year. Sri Lanka, Iran, Mongolia were missed by almost all international investment “strategists”. Could the geographic diversification strategy nowadays be to invest in places that do NOT have ETFs? It’s an Asian century but not in the most heavily hyped markets.

Unlike the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers properly incentivized to work hard and apply rare skills to their money and yours will deliver in all possible scenarios over time. Changing markets and rising correlation are no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is important. Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid managers dependent on the market and focus on skill-based absolute return strategies.

by Veryan Allen. Copyright

Go to Source

Correlation? Are “all” securities moving together? Correlation is a misleading statistic that has little to do with achieving diversification. Highly correlated funds CAN hedge a portfolio whereas some uncorrelated strategies are too dependent on underlying markets. Below is a hypothetical hedge fund with a +1.00 correlation to the S&P500. Despite absolute returns EVERY year and +17.65% CAGR, it’s perfectly correlated with a benchmark that lost money!

Beta is usually cited as a measure of volatility. But it’s more a correlation adjusted for the relative volatilities of the fund and index. You can have a low beta fund that is very risky and a high beta fund less risky than the market. Idiosyncratic risk isn’t a risk; it is the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t very helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is much more complicated.

Correlation rising? Diversification is often called the only free lunch but that seems to be being arbitraged away in risky asset classes. Correlation is used by many as a critical input for portfolio construction and risk management. During crashes, correlations tend to one but now it can occur in “normal” market conditions as well. Securities may move more in sync now due to herding, ETFs and algorithmic trading. The “passive” index fund mania means many benchmark components go up or down regardless of value whether stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long. And with skill-based strategies that offer absolute alpha not repackaged beta.

The all powerful correlation matrix drives traditional portfolio “optimization”. A bunch of input estimates probably incorrect and whose output can be extremely error prone. Garbage in, garbage squared out. Correlation is not a good measure of magnitude. On up market days most stocks may go up but they don’t rise by the same percentage. Relative value strategies take advantage of different security price gains even when in the same direction. I don’t mind if an investment has a correlation of 1, 0, -1 or anything in between. It is irrelevant. I do care that it has minimized dependence on anything else in the portfolio.

“Modern” portfolio theory requires three sets of wild guesses: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in such a way and the poor “results” speak for themselves. Those variables aren’t robust, stable or likely to be accurate in constructing a long term portfolio. It is not surprising conventional wisdom has done so badly with Nobel prizes awarded for such “efficient”, mean variance “optimized”, CAPM nonsense. Past asset class returns are NO indication of future performance over any time horizon, standard deviation does not measure risk and correlation provides no insight on risk factor dependence. So why is this still voodoo economics in use?

Dispersion? Every month reports come out on how “hedge funds” have done on average. Those numbers are meaningless with such a disparity of skills. Most of the mainstream strategies are too well-known now so it is no surprise AGGREGATE returns are tending to zero. Skill is rare. The average hides a wide range of numbers from managers performing very well to those that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to identify manager skill instead of luck.

The best sources of low dependence are time and space diversification. High frequency trading continues to perform well. Amazing how most portfolios still don’t allocate to such a valuable source of alpha. 2008 was great and returns have been good this “difficult” year. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors fear rather than favor high frequency strategies, yet. Perhaps buy and hold for a few milliseconds is the natural evolution from buy and hold for a few decades.

There is a big difference between a good strategy and a bad one. Emerging markets have also had huge dispersion with frontier markets tending to do better. Frontiers are less connected to the world economy while emerging markets is often semantic arbitrage for several countries that are actually developed. The old BRIC underperformed the new BRIC but the SLUM has been the rockstar this year – Sri Lanka, Ukraine, Mongolia – but missed by almost everyone including alleged emerging markets “experts”. Could the geographic outperformance strategy nowadays be to invest in places that do NOT have ETFs? Less dependence rearing its ugly head.

Unlike the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers incentivized to work hard and apply their skills will deliver over time in all possible scenarios. Changing markets and rising correlation are no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low similarity between strategies is so important. Two funds might or might not be correlated but one can be vastly superior and safer than the other. Avoid anything dependent on the economy and focus on skill-based absolute return strategies. I prefer calculating coRelation metrics not coRRelations.

by Veryan Allen. Copyright

Go to Source

Correlation? Much talk of high correlations these days amid complaints of “all” securities moving together. But correlation is a misleading metric that has little to do with true diversification. While very correlated funds CAN hedge a portfolio, some uncorrelated strategies are too dependent on underlying markets. Below is a hypothetical fund with correlation of +1.00 to the S&P500. Despite absolute returns every year and +17.65% CAGR, it is perfectly correlated with a benchmark that lost money. So I prefer to calculate coRelations not coRRelations.

Correlation rising? Diversification is often cited as the only free lunch but that seems to be being arbitraged away in risky asset classes. Correlation is used by many as a critical input for portfolio construction and risk management. During crashes, correlations go up but now it occurs in “normal” market conditions as well. Securities may move more in sync now due to herding, ETFs and algorithmic trading. Also the index fund mania means many benchmark components go up or down regardless of value whether stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long. And with skill-based strategies that offer absolute alpha not repackaged beta.

Beta is often cited as a measure of volatility. But it’s more a correlation adjusted for the relative volatilities of the fund and index. You can have a low beta fund that is very risky and a high beta fund that is less risky than the market. Idiosyncratic risk isn’t a risk; it is the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t very helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is much more complicated.

The all powerful correlation matrix drives much portfolio “optimization”. A bunch of input estimates highly probable to be incorrect and whose output can be extremely error prone. Garbage in, garbage squared out. Correlation is also not a good measure of magnitude. On up market days “every” stock or bond may go up but they don’t rise by the same percentage. Relative value strategies take advantage of different security moves even when in the same direction. I don’t mind if an investment has a correlation of 1, 0 or -1 and anything in between. I do care that it has minimal coRelation with anything else in the portfolio.

“Modern” portfolio theory is based on three sets of guesses: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this way and the “results” speak for themselves. Those guesses aren’t robust, stable or likely to be accurate in constructing a performing portfolio for the long term. It is not surprising conventional wisdom has done so badly with Nobel prizes awarded for such “efficient”, optimized CAPM nonsense. Past asset class performance is no indication of future performance over any time horizon, standard deviation does not measure risk and correlation provides little information on risk factor dependence. So why is this still in use?

Dispersion? Every month reports come out on how “hedge funds” have done on average. Those numbers are meaningless with such a disparity of skills. Most of the mainstream strategies are too well-known now so it is no surprise AGGREGATE returns are tending to zero. The average hides a wide range of numbers from managers performing very well to those that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to identify skill instead of luck.

The best sources of low coRelation are time and space diversification. High frequency trading continues to perform well. Amazing how many portfolios STILL don’t have an allocation to such a valuable source of alpha and non-coRelated returns. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors do not allocate to high frequency strategies, yet. Perhaps buy and hold for a few milliseconds is the natural evolution of buy and hold for a few decades.

As with all strategies there is a big difference between a good HFT strategy and a bad one. Emerging markets have also had huge dispersion with frontier markets tending to do better. Frontiers are less coRelated to the world economy while emerging markets is often semantic arbitrage for several countries that are actually developed. The old BRIC underperformed the new BRIC but the SLUM has been the rockstar this year – Sri Lanka, Ukraine, Mongolia. Could the geographic outperformance strategy nowadays be to invest in places that do NOT have an ETF? Less danger of coRelation rearing its ugly head.

In preference to the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers in the world incentivized to work hard and apply their skills will deliver over time in all possible scenarios. Changing markets and rising correlations are no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low coRelation between strategies is so important. Two funds might or might not be highly correlated but one can be vastly superior and safer than the other. Avoid anything highly coRelated to the economy and focus on skill-based absolute return strategies.

by Veryan Allen. Copyright

Go to Source

Correlation? Lot of talk on high correlations these days amid complaints of “all” securities moving together. But correlation is a misleading metric that has little to do with true diversification. While correlated funds can hedge a portfolio, it is common for uncorrelated strategies to be too dependent on underlying markets. Below is a hypothetical fund with correlation of 1.00 to the S&P500. Despite that +17.65% CAGR, it is perfectly correlated with a benchmark that lost money! I prefer to measure coRelations not coRRelations.

Correlation rising? Diversification is often cited as the only free lunch but that seems to be being arbitraged away in risky asset classes. Correlation is used by many as a critical input for portfolio construction and risk management. During crashes, correlations go up but now it occurs in “normal” market conditions as well. Securities may move more in sync now due to herding, ETFs and algorithmic trading. Also the index fund mania means many benchmark components go up or down regardless of value whether stocks, bonds or commodities. The best way to diversify a long is with a short NOT another long. And with skill-based strategies that offer absolute alpha not repackaged beta.

Beta is often cited as a measure of volatility. But it’s more a correlation adjusted for the relative volatilities of the fund and index. You can have a low beta fund that is very risky and a high beta fund that is less risky than the market. Idiosyncratic risk isn’t a risk; it is the idiosyncratic alpha you want. Alpha and absolute returns are not the same. The textbook calculation of beta and alpha is based on correlation which, as the example above shows, isn’t very helpful. The identification of true beta – dependence on underlying risk factors – and true alpha – value added through skill not luck – is much more complicated.

The all powerful correlation matrix drives much portfolio “optimization”. A bunch of input estimates highly probable to be incorrect and whose output can be extremely error prone. Garbage in, garbage squared out. Correlation is also not a good measure of magnitude. On up market days “every” stock or bond may go up but they don’t rise by the same percentage. Relative value strategies take advantage of different security moves even when in the same direction. I don’t mind if an investment has a correlation of 1, 0 or -1 and anything in between. I do care that it has minimal coRelation with anything else in the portfolio.

“Modern” portfolio theory is based on three sets of guesses: expected returns, expected volatilities and expected correlations. Scary how trillions are invested in this way and the “results” speak for themselves. Those guesses aren’t robust, stable or likely to be accurate in constructing a performing portfolio for the long term. It is not surprising conventional wisdom has done so badly with Nobel prizes awarded for such “efficient”, optimized CAPM nonsense. Past asset class performance is no indication of future performance over any time horizon, standard deviation does not measure risk and correlation provides little information on risk factor dependence. So why is this still in use?

Dispersion? Every month reports come out on how “hedge funds” have done on average. Those numbers are meaningless with such a disparity of skills. Most of the mainstream strategies are too well-known now so it is no surprise AGGREGATE returns are tending to zero. The average hides a wide range of numbers from managers performing very well to those that are not. 2008 saw huge dispersion. The average hedge fund lost 20% but 3,000 made money. True diversification costs 2 and 20 and the quantitative and qualitative resources to identify skill instead of luck.

The best sources of low coRelation are time and space diversification. High frequency trading continues to perform well. Amazing how many portfolios STILL don’t have an allocation to such a valuable source of alpha and non-coRelated returns. If algos do constitute 65% of all trading in liquid securities, perhaps a model portfolio should have 65% allocated to HFT? Even after so many years of superior risk adjusted returns most investors do not allocate to high frequency strategies, yet. Perhaps buy and hold for a few milliseconds is the natural evolution of buy and hold for a few decades.

As with all strategies there is a big difference between a good HFT strategy and a bad one. Emerging markets have also had huge dispersion with frontier markets tending to do better. Frontiers are less coRelated to the world economy while emerging markets is often semantic arbitrage for several countries that are actually developed. The old BRIC underperformed the new BRIC but the SLUM has been the rockstar this year – Sri Lanka, Ukraine, Mongolia. Could the geographic outperformance strategy nowadays be to invest in places that do NOT have an ETF? Less danger of coRelation rearing its ugly head.

In preference to the unreliable, unskilled, unhedged trio of unknown FUTURE asset class statistics, I know that the best managers in the world incentivized to work hard and apply their skills will deliver over time in all possible scenarios. Changing markets and rising correlations are no excuse for not being able to make money. Of course no-one avoids losses sometimes which is why risk management and low coRelation between strategies is so important. Two funds might or might not be highly correlated but one can be vastly superior and safer than the other. They key is to avoid anything highly coRelated to the economy and focus on skill-based absolute return strategies.

by Veryan Allen. Copyright

Go to Source

Stocks or bonds? The BRIC versus BRIC trade has produced good returns this “challenging” year. Since I wrote about it, long Colombia/short China returned +50%, long Indonesia/short India +30%, Bangladesh beat Brazil and Romania rocked Russia. Relative value doesn’t often make money on both sides. Despite China hype, $1m in Colombia in 2000 is now $25m but just $2m from China and losses in developed countries. Economic growth doesn’t imply strong stock markets but I’m more glad I didn’t tie up peoples’ capital in “risk free” T-bills. Long only? Too risky so I’ll leave the bond bubble to others. Choose SAFER alternatives.

Seek alpha or bet on beta? Why does most financial advice fixate on how much to allocate to various betas? The more “risk averse” the more in bonds? Is it sensible to maintain the same static allocation at 1% yields as when they paid 10%? Can opportunity cost, interest rate and default risk be ignored with coupons so low and borrowing so high? There are NO risk free bonds but at least higher yields delivered the fixed-income on which many individuals and institutions depend. Financial regulation has as much chance of preventing the NEXT crash as ordering the ocean to stop rogue waves. Get sunk AGAIN or benefit from them?

I’ve researched many successful investors and a common factor is that none paid attention to asset allocation. Instead they analyzed securities and timed markets. I have also studied numerous unsuccessful investors and they all put asset allocation front and center. Conclusions: 1) why waste time on something that the best don’t? 2) asset allocation drives returns ONLY if you decide to emphasize it. Selecting which beta to track and then search for funds to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is finding good unconstrained managers and let them figure out how to produce absolute returns. Passive “managers” take no action regardless of risks on the radar. Fiduciary duty? Better to focus on skilled strategies not unskilled asset classes.

Many investors suffer from Anton’s syndrome. They think they can see but they can’t. The mind confabulates a vision of smooth-sailing for their portfolio. Investment inertia and the endowment effect favors what they own not what they should own. Chronic cases delude themselves that efficient frontier combinations of unhedged asset classes will achieve +8% over the long term. Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me cannot. Security analysis is a waste of time so buy them “all”? Whether inflation, deflation or biflation, the 60/40 portfolio is “optimized” for all yields and default probabilities? Buy even more bonds if you “see” yourself as conservative?

What if your required return is much higher? Worrying how quickly 2008 is being forgotten and falling off track records. Asset class amnesia is hazardous but financial anosognosia is worse. To have a defect is bad but to be unaware you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know they don’t know. Using financial legerdemain that masks huge risks, famous index fund clairvoyants sell their “vision” that everything will be fine one day. I hope passive stock and bond portfolios don’t die before then. How many planned retirements and retirement plans were wrecked by long only? Too many. A bond bull market is almost as bad for liability matching as a stock bear market. Pension underfunding is considerably worse discounted at CURRENT government and corporate bond yields.

Asset allocation varying by age? High opportunity cost putting capital in low yield securities. Bonds are good to trade but not buy and hold anymore. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of centenarians needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The gradual switch from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha strategies. The bond bull market has persisted for 30 years. Long only funds are like the Titanic; unsinkable till they do. Portfolio lifeboats include puts, shorts, derivatives and most importantly ALPHA for when beta hits the iceberg. Again.

Portfolio dead weight? High grade bonds were thought to match liabilities. They did once but now they do not. More a liability mismatch. A flat to down equity market combined with lower interest rates is not positive for the pension crisis. If you need an +8% income you can hope the stock market will deliver that “expected” return or focus on better alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for higher risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises as bond yields decline.

Keep it simple investing? Occam’s razor? The only bar in William of Ockam’s home town is called The Black Swan. Simplicity requires preparing for the worst case, most “unlikely” situations. I don’t worry about unlikely events happening. I presume they are imminent and act accordingly. Every investor should apply a PROPER stress test to their portfolio. Instead of VaR, assume all stocks, bonds and real estate are worth ZERO tomorrow morning. Preparing for the doomsday scenario is true risk management. It has happened several times in many places in the past. That is not economic eschatology; it is prudent fiduciary duty. How many investors are ready for a 90% global stock market crash and widespread debt defaults? If not why not?

Someone asked my forecast for the Dow 1 year from now with 90% confidence. My best guess is between 0 and 20,000. That is as tight a bid-offer spread as I can manage. Predictive accuracy declines exponentially with time. While the Dow might never see 20,000 it is a physical and astronomic CERTAINTY it will one day fall to zero. Before then there are numerous armageddon scenarios that would nullify the stock market. Just takes a few drunken generals or mad scientists accidentally pressing the big red button. How do you know a large asteroid isn’t on its way here? What would assets be worth if a black hole from a Magnetar was discovered headed towards us? If it can happen it will happen is not a prediction, it’s a philosophy. Buy and hopers should remember that they are betting AGAINST the inevitable end-game. The true long term drift is down.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. 2008 offered an expensive investment lesson for risky long only but still some invest in index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled AND unaware of it. Scarier than a real black hole but with similar results. No-one with a sensible risk tolerance invests a cent in index funds.

Invest in alpha opportunity sets. How much to allocate to “emerging markets”? How much to “submerging markets”? So many countries, cultures and disparate outlooks for all those stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers” once? The China economy is larger than 3 years ago but the stock market is over 60% below its high water mark. The Japan economy is bigger than 20 years back but Nikkei 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? Every investor needs 100% in skilled strategies and that requires a lot of analysis and due diligence.

Search for yield? Not long back many experts said inflation was inevitable so short sell bonds but now deflation is the hot topic so buy them instead? Many gurus have lost big money shorting JGBs over the years but now treasuries are doing the same. If you need an explanation for the rally it is as much a short squeeze as flight to “safety”. Trade bonds but don’t hold them. Just like stocks. Applied skillfully, long/short equity is safer than long only. I’ll take long/short credit, fixed-income arbitrage and distressed debt strategies over unhedged “investment grade” bonds every time. Some returns do compensate for the risks. Asset classes never do including during bull and bubble markets.

by Veryan Allen. Copyright

Go to Source

Bonds or stocks? A good alpha source this year has been BRIC versus BRIC. Since I disclosed it, long Colombia/short China returned +50%, long Indonesia/short India +30%, Bangladesh beat Brazil and Romania rocked Russia. Relative-value strategies don’t often make money on both sides. While economic expansion does not imply stock market growth, I’m more glad I didn’t tie up peoples’ cash in “risk free” cash. Long only? Too risky so I’ll leave the bond bubble to others. Absolute return is the safer alternative.

Seek alpha or bet on beta? Why does so much financial advice fixate on how much to allocate to various betas? The more “risk averse” the more in bonds? Is it sensible to recommend the same allocation at 1% yields as when they paid 10%? Can opportunity cost and default risk be ignored with coupons so low and borrowing so high? There are NO risk free bonds but at least higher yields delivered the fixed-income on which so many individuals and institutions depend. Financial regulation has as much chance of preventing the NEXT crash as ordering the ocean to stop rogue waves. Get sunk again OR benefit from them? You choose.

Better to focus on skilled strategies that hedge risks competently. I’ve researched many successful investors and one common factor is that none paid attention to asset allocation. Instead they selected securities and/or timed markets. I also studied many more unsuccessful investors that put asset allocation front and center. Conclusions: 1) why waste time on something that the best don’t? 2) asset allocation only drives returns if you decide to emphasize it. Selecting which betas to track and then search for managers to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is finding good unconstrained managers and let them figure out how to produce absolute returns. Passive “managers” take no action regardless of the risks on the radar. Fiduciary duty?

Many investors suffer from Anton’s syndrome. They think they can see but they can’t. The mind confabulates a vision of smooth-sailing for their portfolio. Investment inertia and the endowment effect favors what they own not what they should own. Some chronic cases delude themselves that “efficient frontier” combinations of unhedged asset classes will achieve +8% over the long term. Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me cannot. Security analysis is a waste of time so buy them “all”? Whether inflation, deflation or biflation, the 60/40 portfolio is “optimized” for all yields, risks and default probabilities? Buy even more bonds if you “see” yourself as conservative!

What if the required return is much higher? Worrying how quickly 2008 is being forgotten and falling off track records. Asset class amnesia is hazardous but financial anosognosia is worse. To have a defect is bad but to be unaware you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know they don’t know. Famous index fund clairvoyants sell their “vision” that everything will be fine one day. I hope passive stock and bond portfolios don’t die before then. How many planned retirements and retirement plans were wrecked by long only? Too many. A bond bull market is almost as bad for liability matching as a stock bear market. Pension underfunding is considerably worse discounted at CURRENT government and corporate bond yields.

Asset allocation varies by age? High opportunity cost putting capital in low yield securities. Bonds are good to trade but not buy and hold anymore. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of centagenarians needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The switchover from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha strategies. The bond bull market has persisted for 30 years. Long only funds are like the Titanic; unsinkable till they do. Portfolio lifeboats include puts, shorts, derivatives and most importantly ALPHA for when beta hits the iceberg. Again.

Portfolio dead weight? High grade bonds are considered to be a liability match. They were once but now they are not. More a liability mismatch. A flat to down equity market combined with lower interest rates is not positive for underfunding. If you need an +8% income you can bet on “high” yield junk bonds, hope the stock market will deliver that “expected” return or focus on SAFER alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for better risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises directly as a function of bond yields.

Keep it simple investing? Occam’s razor? The only bar in William of Occam’s home town is called The Black Swan. Simplicity requires preparing for the worst case, most “unlikely” situations. I don’t worry about unlikely events happening. I presume they are imminent and act accordingly. Every investor should apply a PROPER stress test to their portfolio. Instead of VaR, assume all stocks, bonds and real estate are worth ZERO tomorrow morning. Preparing for the doomsday scenario is true risk management. It has happened several times in many places in the past. That is not economic eschatology; it is prudent fiduciary duty. How many investors are ready for a 90% global stock market crash and widespread debt defaults? If not why not?

Someone asked my forecast for the Dow 1 year from now with 90% confidence. My best guess is between 0 and 20,000. That is as tight a bid-offer spread as I can manage. Predictive accuracy declines exponentially with time. While the Dow might never see 20,000 it is a physical and astronomic CERTAINTY it will one day fall to zero. Before then there are numerous armageddon scenarios that would nullify the stock market. Just takes a few drunken generals or mad scientists accidentally pressing the big red button. How do you know a large asteroid isn’t on its way here? What would assets be worth if a black hole from a Magnetar was discovered headed towards us? If it can happen it will happen is not a prediction, it’s a philosophy. Buy and hopers should remember that they are betting AGAINST the inevitable end-game. The true long term drift is down.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. 2008 offered a valuable and expensive investment lesson for risky long only but still some invest in index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled AND unaware of it. Scarier than a real black hole but with similar results.

Invest in alpha opportunity sets. How much to allocate to “emerging markets”? How much to “submerging markets”? So many countries, cultures and disparate outlooks for all those stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers” once? The China economy is larger than 3 years ago but the stock market is over 60% below its high water mark. The Japan economy is bigger than 20 years back but Nikkei 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? Every investor needs 100% in skilled strategies at that requires a lot of analysis and due diligence.

Search for yield? A few months back many experts said inflation was inevitable so short bonds but now deflation is the hot topic so buy them instead? A long list of gurus have lost big money shorting JGBs over the years but now treasuries are doing the same. If you need an explanation for the rally it is as much a short squeeze than flight to “safety”. Trade bonds but don’t hold them. Just like stocks. Applied skillfully, long/short equity is safer than long only. And I’ll take thoroughly analyzed long/short credit, fixed-income arbitrage and distressed debt strategies over unhedged “investment grade” bonds every time. Some returns do compensate for the risks. Asset classes never do including during bull and bubble markets.

by Veryan Allen. Copyright

Go to Source

Bonds or stocks? A nice investment this year has been the bric versus BRIC trade. Since I wrote about it, long Colombia/short China returned +50%, long Indonesia/short India +30%, Bangladesh bettered Brazil and Romania rose past Russia. Beta-neutral relative value emerging market strategies usually don’t make money on both sides. While economic expansion does NOT imply stock market growth, I’m more glad I didn’t tie up peoples’ cash in “risk free” cash. Long only? Too risky so I’ll leave others to chase the bond bubble. Absolute return is the SAFER alternative.

Seek alpha or bet on beta? Why does so much financial advice fixate on how much to allocate to various betas? The more “risk averse” the more in bonds? Is it sensible to recommend the same allocation at 1% yields as when they paid 10%? Can opportunity cost and default risk be ignored with coupons so low and borrowing so high? There are NO risk free bonds but at least higher yields did deliver the fixed-income on which so many individuals and institutions depend. Financial reform and regulation has as much chance of preventing the NEXT crash as ordering the ocean to stop rogue waves. Get sunk again OR benefit from them? Investors can choose.

Many suffer from Anton’s syndrome. They think they can see but they can’t. The mind confabulates a vision of smooth-sailing for their portfolio. Investment inertia and the endowment effect favors what they own not what they should own. Those with a chronic case delude themselves that some “efficient frontier” combination of stocks and bonds can achieve +8% CAGR over the long term! Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me cannot. Security analysis is a waste of time so buy “all” securities despite the FACT that 75% of stocks are long term lemons. Whether inflation, deflation or biflation, own bonds as the 60/40 portfolio is “optimized” for all yields, risks and default probabilities? Buy even more bonds if you “see” yourself as “conservative”! And there is NO risk if you hold stocks long enough?

What if your required return is much higher? With 2008 rapidly being forgotten and falling off track records, asset class amnesia is hazardous but financial anosognosia is worse. To have a defect is bad but to not know you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know that they don’t know. Famous clairvoyants sell their “vision” that everything will be fine one day. Hopefully passive stock and bond portfolios won’t die before then. How many planned retirements and retirement plans have been wrecked by long only index funds? Too many. A bond bull market is almost as bad for liability matching as a stock bear market! The pension underfunding crisis is considerably worse discounted at CURRENT government and corporate bond yields.

I’ve researched many successful investors and one common factor is that none paid attention to asset allocation. Instead they selected securities and/or timed markets. I also studied many unsuccessful investors and found they put asset allocation front and center. Conclusion: 1) asset allocation only drives returns if you DECIDE to emphasize it, 2) why waste time on something that the best don’t? Better to have the entire portfolio in skilled strategies. Selecting which betas to track, then searching for managers to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is to choose good unconstrained managers and let them figure out how to produce absolute returns. Portfolio lifeboats include puts, shorts, derivatives and most importantly ALPHA for when beta inevitably hits the iceberg. Again. Index funds are like the Titanic; unsinkable till they do. So hedge.

Asset allocation varies by age? High opportunity cost putting capital in low yield securities. Bonds are good to trade but not buy and hold anymore. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of centagenarians needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The switchover from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha opportunities. The bond bull market has persisted for 30 years.

Portfolio dead weight? High grade bonds are considered to be a liability match. They were once but now they are not. More a liability mismatch. A flat to down equity market combined with lower interest rates is not positive for underfunding. If you need an +8% income you can bet on “high” yield junk bonds, hope the stock market will deliver that “expected” return or focus on SAFER alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for better risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises directly as a function bond yields.

Keep it simple investing? Occam’s razor? The only bar in William of Occam’s home town is called The Black Swan. Simplicity requires preparing for the worst case, most “unlikely” situations. I don’t worry about unlikely events happening. I presume they are imminent and act accordingly. Every investor should apply a PROPER stress test to their portfolio. Instead of VaR, assume all stocks, bonds and real estate are worth ZERO tomorrow morning. Preparing for the doomsday scenario is true risk management. It has happened several times in many places in the past. That is not economic eschatology; it is prudent fiduciary duty. How many investors are ready for a 90% global stock market crash and widespread debt defaults? If not why not?

Someone asked my forecast for the Dow 1 year from now with 90% confidence. My best guess is between 0 and 20,000. That is as tight a bid-offer spread as I can manage. Predictive accuracy declines exponentially with time. While the Dow might never see 20,000 it is a physical and astronomic CERTAINTY it will one day fall to zero. Before then there are numerous armageddon scenarios that would nullify the stock market. Just takes a few drunken generals or mad scientists accidentally pressing the big red button. How do you know a large asteroid isn’t on its way here? What would assets be worth if a black hole from a Magnetar was discovered headed towards us? If it can happen it will happen is not a prediction, it’s a philosophy. Buy and hopers should remember that they are betting AGAINST the inevitable end-game. The true long term drift is down.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. 2008 offered a valuable and expensive investment lesson for risky long only but still some invest in index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled AND unaware of it. Scarier than a real black hole but with similar results.

Invest in alpha opportunity sets. How much to allocate to “emerging markets”? How much to “submerging markets”? So many countries, cultures and disparate outlooks for all those stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers” once? The China economy is larger than 3 years ago but the stock market is over 60% below its high water mark. The Japan economy is bigger than 20 years back but Nikkei 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? Every investor needs 100% in skilled strategies at that requires a lot of analysis and due diligence.

Search for yield? A few months back many experts said inflation was inevitable so short bonds but now deflation is the hot topic so buy them instead? A long list of gurus have lost big money shorting JGBs over the years but now treasuries are doing the same. If you need an explanation for the rally it is as much a short squeeze than flight to “safety”. Trade bonds but don’t hold them. Just like stocks. Applied skillfully, long/short equity is safer than long only. And I’ll take thoroughly analyzed long/short credit, fixed-income arbitrage and distressed debt strategies over unhedged bonds every time. Some returns DO compensate for the risks.

by Veryan Allen. Copyright

Go to Source

Buy bonds or stocks? A nice investment this year has been the bric versus BRIC trade. Since I disclosed it the long Colombia/short China position returned +50%, long Indonesia/short India +30%, Bangladesh bettered Brazil and Romania romped past Russia. Beta-neutral relative value strategies rarely make money on both sides. While economic expansion does not imply stock market growth, I’m more glad I didn’t tie up cash in “risk free” bonds.

Search for yield? Not long ago many experts said inflation was inevitable so short bonds but now deflation is the hot topic so buy them instead? There is a long list of gurus that lost big money short selling JGBs over the years but now treasuries are doing the same to them. If you need an explanation for the bond rally it is more a short squeeze than flight to “safety”. Trade bonds but don’t hold them. Just like stocks. Applied skillfully, long/short equity is safer than long only. And I’ll take fixed-income arbitrage and distressed debt strategies over “investment grade” bonds.

Seek alpha or bet on beta? Why does so much financial advice fixate on the irrelevant topic of how much to allocate to asset classes? The more “risk averse” the more in bonds? Is it sensible to recommend the same allocation if they yield 2% as when they paid 10%? Can opportunity cost and default risk be ignored with coupons so low and borrowing so high? There are no risk free bonds but at least higher yields delivered the fixed-income on which so many individuals and institutions depend. Absolute return is the alternative.

Asset allocation varies by age? Big opportunity cost putting capital in low yield securities when higher returns are needed. There are no stable laws in finance. Conventional wisdom was to put one’s age in “bonds” and the rest in “stocks”. But the rapidly growing cohort of 100 year olds needs an adequate income too. Why should a 20 year old have 80% in stocks? Because equities supposedly rise if you own them long enough? The switchover from stocks to bonds over time doesn’t cut it. More sensible is to have 100% of the portfolio in alpha opportunities. The bond bull market has persisted for 30 years. Deflation fears may fuel more. But higher returns are necessary.

I’ve researched many successful investors and one common factor is that none paid any attention to asset allocation. I also studied unsuccessful investors desperately trying to fund retirement liabilities and found they put asset allocation front and center. A clear pattern and conclusion. Cognitive error: asset allocation only drives returns if you DECIDE to emphasize it. Selecting which betas to track, then searching for managers to deliver it (and maybe a bit of alpha) hasn’t worked. What does work is to choose skilled unconstrained managers and let them figure out how to produce absolute returns.

How much to allocate to “emerging markets”? What kind of question is that? How much to “submerging markets”? So many countries, cultures and disparate outlooks for thousands of stocks, bonds, commodities and currencies. “Frontier markets” don’t have long track records but weren’t all countries “frontiers”? The China economy is larger than 3 years ago but is over 60% below its high water mark. The Japan economy is bigger than 20 years back but 75% off its high. Plenty of Chinese and Japanese securities are doing well as are the good hedge funds that focus on finding them and short ideas. How much should you allocate to “hedge funds”? The average hedge fund is as bad as the average long only stock or bond fund. But every investor needs 100% in skilled strategies.

Portfolio dead weight? High grade bonds are considered to be a liability match. They were once but now they are not. More a liability mismatch. If you need an +8% income you can bet on “high” yield junk bonds, hope the stock market will deliver that “expected” return or focus on SAFER alternatives. At such low yields, every cent in “risk free” bonds is a wasted chance for better risk-adjusted performance. Also not enough bond buyers are worrying about return OF their capital. There are superior investment opportunities available. The attraction of skill-based strategies rises directly with bond prices.

A disease many investors suffer from is Anton’s syndrome. They think they can see but they can’t. Their mind confabulates a rosy vision for the market. Investment inertia and the endowment affect makes them favor what they own not what they should own. Bonds going up? Keep them or miss the rally. Market timing is “impossible” so buy and hold for the economic utopia they can see but blind people like me can’t. Security analysis is a waste of time so buy them all despite the FACT that 75% of stocks are long term lemons. Own bonds since the classic 60/40 portfolio is “optimized” for all yields, risks and default probabilities! Buy more bonds if you “see” yourself as “conservative”?

With 2008 rapidly being forgotten and falling off track records, asset class amnesia is dangerous but financial anosognosia is even worse. To have a defect is bad but to not know you have the defect is dangerous. The world divides into the few that know they don’t know and the many that don’t know they don’t know. Thankfully famous clairvoyants are able to see that everything will be fine in the end. Hopefully passive stock and bond portfolios won’t die before then. How many planned retirements and retirement plans have been wrecked by long only “passive”? Too many. Financial reform and regulation has as much chance of preventing the NEXT crash as ordering the ocean to stop rogue waves.

Keep it simple investing? Occam’s razor? The only bar in William of Occam’s home town is called The Black Swan. Simplicity requires preparing for the worst case, most “unlikely” situations. I don’t worry about unlikely events happening. I presume they are imminent and act accordingly. Every investor should apply a PROPER stress test to their portfolio. Instead of VaR, assume all stocks, bonds and real estate are worth ZERO tomorrow morning. Preparing for the doomsday scenario is true risk management. It has happened several times in many places in the past. That is not economic eschatology; it is prudent fiduciary duty. How many investors are ready for a 90% global stock market crash and widespread debt defaults? If not why not?

Someone asked my forecast for the Dow 1 year from now with 90% confidence. My best guess is between 0 and 20,000. That is as tight a bid-offer spread as I can manage. Predictive accuracy declines exponentially with time. While the Dow might never see 20,000 it is a physical and astronomic CERTAINTY it will one day fall to zero. Before then there are numerous armageddon scenarios that would nullify the stock market. Just takes a few drunken generals or mad scientists accidentally pressing the big red button. How do you know a large asteroid isn’t on its way here? What would assets be worth if a black hole from a Magnetar was discovered headed towards us? If it can happen it will happen is not a prediction, it’s a philosophy. Buy and hopers should remember that they are betting AGAINST the inevitable end-game. The true long term drift is down.

Risk management? Thinking the unthinkable is an essential requirement for portfolio construction. The recent “flash crash” was a reminder of the ephemeral “value” in the markets. It came back, that time. I observed the wealth destruction delivered by long only equity funds in the 1990 Japan crash and 1987 Black Monday. Back in 1982 a Kuwaiti friend’s family office lost everything in the Middle East crash. Oil riches don’t automatically translate to stock market wealth. 2008 offered a valuable and expensive investment lesson but still some invest in losers like index funds. Two -50% drawdowns in a decade and MUCH worse coming in the future. It’s the notorious Dunning-Kruger effect. Many people think they are smarter than they are which is why we get bubbles and crashes. Unskilled and unaware of it. Scarier than a real black hole.

by Veryan Allen. Copyright

Go to Source