That’s Not a Sell-Off, THIS is a Sell-Off

May 23, 2013 By Leave a Comment

Only a couple of days after we reposted a chart from Stocktwits comparing the Nikkei rally to the Dow’s climb over the last year, and suddenly things have turned very sour for the Japanese market:

Chart courtesy Finviz.com. Disclaimer: past performance is not necessarily indicative of future results.

Meanwhile, the Dow’s drop in the early hours this morning proved to be little more than a head fake, as the market came all the way back only a few hours later:

Chart courtesy Finviz.com. Disclaimer: past performance is not necessarily indicative of future results.

And don’t let the scale of those two charts fool you – the drop from yesterday’s high in the Dow to today’s low was less than a 2% drop, while the Nikkei decline from yesterday’s highs to today was more than 8%.

It’s just one day’s hiccup in a long, huge climb for both markets, but it looks like at least one piece of evidence that the Japanese surge may be starting to get a little frothy.

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Gensler’s MF Global Getaway

May 22, 2013 By Leave a Comment

As MF Global continues unwinding at the speed of bureaucracy, new pieces of information have been few and far between. But this week, the Inspector General of the CFTC released a report examining the CFTC’s oversight and regulation of MF Global (you can read the full report here).

It’s definitely not groundbreaking, but the part of the report getting the most attention is CFTC Chairman Gary Gensler’s decision to recuse himself from the investigation – particularly whether or not that was in line with the CFTC’s policies. As it turns out, he was advised that it would not be consistent with established policy for him to do so, but that didn’t seem to be the answer he wanted. The Wall Street Journal writes:

“[W]e are concerned with the Chairman’s determination to withdraw from participation” in the investigation, the inspector general’s report concludes, noting that Mr. Gensler’s decision to seek advice on his involvement with MF Global only after the firm became “a public sensation” was “not the most desirable course.”

In other words, Gensler didn’t “realize” that his past ties to Corzine might be a problem until after it became clear that MF Global was going to be a high-profile disaster. It was at that point that he decided it might be a good idea to keep his name far, far away.

Well, it’s good knowing that when the chips are down and the disaster strikes, the head of one of our top regulators has the courage and conviction to step forward and say, “Not It.”

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Alternatives Demand Set to Soar?

May 16, 2013 By Leave a Comment

The growth of managed futures AUM has slowed down recently – a couple of mediocre years while stocks soar will do that. Given what we know about risk and investors’ desire to avoid big drawdowns, we don’t think that will last forever. But even we were a bit surprised by a new survey which claims that demand for retail alternatives (including hedge funds and managed futures) is set to triple in just four years. Via Finalternatives:

Global demand for retail alternative investment products, including hedge funds, will triple by 2017 to $939 billion, according to the latest research from Citi Prime Finance…

The survey, based on 82 interviews with a variety of industry players, predicts retail demand for alternatives will focus on mutual funds and ETFs, which now manage $259 billion and which could manage $770 billion by 2017. Investors in Europe and elsewhere will look to UCITS products while smaller institutional investors will seek lower-fee, publicly offered products,  pushing overall global demand for these “liquid alternatives” to $1.3 trillion, a level equal to the total assets invested in all hedge funds in 2008.

Investors looking to alternative investments is good news, but that growth headed for retail mutual funds and ETFs? It’s frustrating, to say the least. We’ve been very vocal about the problems with these products, and we still think managed accounts are the best way to access the space if you have the capital for it.

That’s not to say that all retail products should send investors running in the opposite direction. We’ve been keeping a close eye on the space for a while now, and while it’s true that most of these funds are horrid – loaded with unnecessary fees and offering a product that is “alternative” only name – there are a handful who appear to be doing it right. Picking them out from amongst the chaff is the tricky part.

It’s good to see more investors seeking  access to alternative investments, but we are a little worried that the flood of bad offerings out there will end up burning investors who are venturing into the space for the first time.

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Trend Following: Not Just for Black Swans

May 16, 2013 By Leave a Comment

The “Most Hated Bull Market” of all time is also proving to be one of the most resilient. It just keeps rubbing salt in the wounds of the bears, and every time the exuberance starts looking irrational, the market puts in another run up. Josh Brown has a great piece summing up just how much sheer wonder is wrapped up in this moment, but we were a bit puzzled by the inclusion of the following statement:

The Black Swans we’d been guessing at have had their necks broken one by one, their heads bashed in. Blood and feathers, a smear on the wall.”

Right off the bat – things that we’re guessing are going to happen aren’t really Black Swans, per Nassim Taleb’s description. A true Black Swan is something that is such an outlier that it can only be rationalized in hindsight… in other words, if cable news personalities chatter about an issue on a daily basis, it’s not a Black Swan (take the Eurozone, for example).

But that quibble aside, what he’s really highlighting is the futility of top-guessing. No one in their right mind, no matter how bullish, is expecting a perfectly smooth upward curve to Dow 30,000 and then on into infinity. The bears are not wrong in saying that a pullback is coming, they are wrong in the conceit that they know exactly when it will strike. Jon Boorman gets it right:

There’s a big difference between expecting a pullback, and predicting or looking for one. I’m not going to change a single thing. I will still let my winners run, and cut my losers. I will continue to ride every uptrend until it’s over, but I am getting to the point where I am expecting to have that definition of when a trend is invalidated put to the test.

This is why a good trend following component is so valuable for investors. It’s not going to be the shining star of your portfolio when times are good. That’s not what it’s there for. But managed futures can still prosper when stocks are on fire (the Newedge CTA Index is up 4.68% so far this year, compared to 16.31% for the S&P 500. Disclaimer: past performance is not necessarily indicative of future results). And when the next market decline hits – whether it’s a Black Swan or a run of the mill pull back – we’re guessing you’ll be glad you diversified.

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Book Review: Fortune’s Formula

May 15, 2013 By Leave a Comment

When a friend of ours headed to the World Series of Poker last summer mentioned basing his bet size on Fortune’s Formula, and we gave him a semi-blank stare – he told us to go pick up the book Fortune’s Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone. So we did. And are we glad we did. Talk about breadth of subject. How about tying in information theory, mobsters, Ivan Boesky, Long Term Capital Management, Rudy Giuliani, and “beat the dealer” in blackjack?

William Poundstone’s book is ostensibly about the Kelly Criterion, a formula used to calculate the optimal bet size given one knows their probability of winning and the payout odds for a winning bet. An example from Wikipedia: if a gamble has a 60% chance of winning (p = 0.60, q = 0.40), but the gambler receives 1-to-1 odds on a winning bet (b = 1), then the gambler should bet 20% of the bankroll at each opportunity (f* = 0.20), in order to maximize the long-run growth rate of the bankroll.

But the real story is the historical characters laid out therein.

There is Claude Shannon – the father of information theory whom Poundstone argues was on Einstein’s level. Ed Thorp, who adapted the Kelly Criterion to card counting and playing blackjack to several successful hedge funds. There is mobster Manny Kimmel, who turned a parking lot won in a craps game into a parking lot company which eventually bought film studio Warner Brothers, which eventually became Warner Communications, and eventually merged with Time Inc. to create the Time Warner whose internet connection you might be using right now. There is the story of a young Rudy Giuliani fighting crime in New York. There is Boesky and Milken and Merton Shcoles and Fisher and Black and Merriwhether. And a great Warren Buffet fable about every person in the US flipping coins we hadn’t seen before.

Then there are the lessons gleaned. Such as why insider trading is so appealing to those utilizing the Kelly criterion (because the odds of success go way up), and how overbetting even on a positive expectancy outcome can result in ruin. There is talk about the failings of VaR and Black Scholes and Long Term Capital Management. And there is the overarching lesson of the Kelly Criterion that risking a fraction of your bankroll (investment amount) on each successive “bet” removes the risk of ruin (ignoring minimum investments or table minimums, and the like) while providing the largest possible long term growth.

Below is the graph from the book comparing four money management systems using a  simple example of even money bets with a 55% chance of winning. You can see the brief flame out of the bet it all bettor. The deceivingly smooth line of the Martingale bettor (if you lose, bet double the next time) except for the large drawdown during a losing streak, the slow and steady gains of the fixed wager – and finally the volatile but largest gainer in the Kelly method. (Excuse the quality of the image – it was pulled from somewhere on Google and likely a scan from the book, not created digitally by us.)

We couldn’t help but keep thinking back to systematic trading models in the managed futures space in reading the book, because fractional betting on the ongoing bankroll is how managed futures operate for the most part: risking a fraction of the investor’s ongoing account on each trade so as to reduce trading during a losing streak and compound winning by larger bet sizes during winning streaks. We know two things for sure. One, we’ll be adding this book to our list of market favorites, and two, we’ll be asking managers we talk to from here on out their views on the Kelly Criterion are… and docking them a few points if we get that blank stare back.

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Wasendorf’s Next Gig

May 1, 2013 By 1 Comment

Russ Wasendorf has already put together his next project. We’re talking about Jr., of course. He’s trying to get back on his feet while the old man sits in jail, having launched what looks to be an eBay/Craigslist fusion to help people sell their old stuff to one another.

Having evidently decided that Cedar Falls holds too many bad memories (and really, who could blame him?), Russ Jr. has relocated to Orlando and launched “Orange Tree Deals.” And he has some  truly edifying thoughts about the role of trust in a marketplace, as well as the dangers of counterparty risk:

Upon arriving to Florida I was looking to start my own business.  I had experience in technology and more importantly I had 25 years of experience in the financial markets.  I understood the basics of a market place were transparency and creating a centralized location for people to meet.  Finally the most important component was trust.  In market terminology it is called counterparty risk which just means the risk the person on the other side of a deal either as the buyer or seller would not deliver goods in the quality promised in the manner promised or that the buyer would not pay with good funds the amount promised.  This risk was diminished by creating a membership where only buyers and sellers that were known to each other could exchange goods for money.  They met face to face and knew each other.  It was very much like a community.  A neighborhood.

With all that’s happened in the last 9 months, we’d say Russ Jr. has a pretty good idea about what counterparty risk means. Considering his firsthand experience, the above is a little much even for us, but we’re trying very hard to reserve judgment. (As long as the Feds keep saying there’s no evidence Jr. knew about his father’s misdeeds, we’ll take him at his word. But, that doesn’t mean we aren’t still rooting for the plaintiffs in the civil case against him.)

And as for his new e-commerce gig, we truly wish him the best of luck. In fact, we’re knocking on wood, donning our lucky rabbit’s foot, and hanging up some horseshoes in his honor. We’re hoping that Orange Tree Deals will take off and become the next big dot-com success story. Hopefully they’ll wind up getting a 100 million IPO or so… and then the proceeds can go to paying PFG clients back the money that was stolen.

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Ditching the 60/40 Mentality

April 23, 2013 By Leave a Comment

The 60/40 portfolio is one of those bits of investment philosophy that’s so deeply ingrained, many people take it for granted. It ranks right up there with “buy low, sell high” for investment advice that’s accepted without question… and it’s about as useful (in other words, not very).

But we’re starting to see that change. Between the financial crisis highlighting the risk in stocks, and the Fed’s “low interest rates forever” policy depressing the returns in a traditional bond portfolio, the 60/40 portfolio is finally on the verge of losing its status as an unchallenged truth of investing. Via Market Watch:

To replace the strategy, some financial professionals are turning to alternative investments—like commodities, foreign currencies, real estate or even private equity—that weren’t easily accessible or widely used when 60-40 method became popular. “Today’s tool kit is better,” says Steve Blumenthal, founder of CMG Capital Management in Philadelphia.

The conundrum is that there now are seemingly as many approaches to asset allocation as investment managers. Some experts advocate the “permanent portfolio” approach, developed by the late investment analyst Harry Browne, which splits money evenly among four asset classes: U.S. stocks, long-term U.S. Treasury bonds, precious metals and cash…

Mr. Blumenthal advocates an even split among three buckets: stocks, bonds and a final grouping he calls “tactical and alternative,” meaning it blends alternative and other investments and can be adjusted as conditions merit.

This news is encouraging – in fact, this was exactly the point of a newsletter we published a few weeks ago. Greater diversification is still one of the best ways to limit downside risk. But branching out beyond the conventional wisdom also puts investors in a tough position. Too many “alternatives” are sold to investors who don’t understand what they’re getting involved in, which is almost always a recipe for a bad experience. For instance, anyone who followed the “four asset class” model Market Watch describes above was probably not too pleased with the way their precious metals performed during last week’s increased volatility (or in 2008 when gold crashed).

Of course, the real take away from this shouldn’t be the idea that there’s a “perfect” allocation model, or that it is forever fixed in stone (sometimes you may want to increase one side and decrease the other to respond dynamically to changing market conditions). In the end, whether it’s 33/33/33 or 42/28/30 or something else, investors need to find a model that they’re comfortable with, and with choices that they understand.

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