Do Investors really have to choose between Rotten Eggs?

It seems like nary a day goes by without a new article popping up hating on diversification. Not because there’s anything really wrong with diversification, but because financial journalism seems to think there’s something wrong with diversification, especially with the S&P at all time highs just a couple weeks ago. Take the recent Market Watch article entitled, “Why Diversification isn’t working.”

Much like the majority of articles out there, the headline is a little deceiving. Author Howard Gold isn’t claiming that the idea of the theory of diversification is flawed, but the application of diversifying your portfolio to include other asset classes in this current climate is flawed, as in his words, “investors have to choose between many bad choices,” implying that there’s nothing out there that can really create a portfolio full of truly diversified asset classes. He even goes as far as calling some of the choices rotten eggs.

“But what if all the baskets were floating in the same direction and the only one that wasn’t was filled with rotten eggs?”

To show that all the basket are floating in the same direction, he shows two tables outlining nine asset classes and their correlation to the S&P 500, one between 2003-2007, and the other from 2008-2012.

Correlation 2003 2007Correlation 2008 2012Charts Courtesy: Market Watch
(Disclaimer: Past performance is not necessarily indicative of future results)

As a refresher: the closer the correlation to 1.00, the higher the correlation, the closer to -1.00, the more negative correlation the two asset classes are, and in-between -0.30 and 0.30 is an example of a non-correlation. His argument, is that among the nine asset classes… the positive correlation to each other are growing – except for in the 20-Year US Treasury Bonds, which he argues are the rotten eggs (because we’re at the end of a 30 year bull market in bonds and prices are likely to fall).

“So, the choice appears to be throwing even more money into stocks, which are nearly five years into a bull market, or buying bonds, which we know will go down in price. Or keeping more in cash (with its negative real return) or stuffing money in the mattress. Or, God forbid, buying leveraged inverse ETFs as a “hedge.”

Now we in the managed futures space love talking non-correlation, and we really like that something like this is getting good attention… but the article is missing a rather big thing in our opinion… Managed Futures. So what does the shift in correlations look like when including managed futures. To do this we used the BarclayHedge BTOP 50 Index.

Managed Futures Correlation 2003 2007Managed Futures Correlation 2008 2012

(Disclaimer: Past performance is not necessarily indicative of future results).

Turns out managed futures has become less correlated to stocks, unlike the other asset classes (or more appropriately – more negatively correlated).  Now, that’s rather obvious from looking at the performance, where managed futures was up while stocks were down in 2008, and has been flat to down since 09 while stocks have been going straight up. (Disclaimer: Past performance is not necessarily indicative of future results).

But we don’t really agree that things are becoming more correlated as of late. Yes, they became very correlated in 2007, 2008, and 2009 – throwing off managed futures and their multi-sector diversification in the process – but since then things have been moving away from that risk on/risk off environment.  As a whole, we’ve been tracking how correlated the futures markets have been to one another, not just other asset classes (i.e. gold futures, corn futures, S&P futures, and so on) (see here, and here), and compared to the 2008-2009 numbers, the correlation has significantly decreased.

So managed futures has remained non correlated, but is that ‘basket’ full of rotten eggs just like bonds?  Not on your life. Indeed, managed futures has had nearly the inverse performance of bonds since 2009, and is at all time lows versus all time highs. The new attitude is to buy into managed futures not just because it will help your portfolio when the s^&% hits the fan, but because it isn’t likely to get much worse from here (although it could).









Diversification: Giving up some home runs, to avoid future strikeouts

We love Carl Richards money doodles on the New York Times ‘Bucks’ blog, but missed this gem of a post he had at the end of last year (literally..on Dec. 31). The topic – diversification.  The angle – diversification isn’t all roses and candy canes. It’s hard to stick to because it involves giving up something (hitting home runs) in order to get something (never striking out).

Diversification bubbleDoodle Courtesy: Bucks Blog via The New York Times

At a time when stocks are at all time highs and managed futures feeling as though it’s at all time lows – it sure pays to remember what they’re doing in the portfolio – so you don’t strike out. But we’ll let the man speak for himself:

The idea [of diversification] is to balance… investments in a way that gives up some higher returns in exchange for lower overall risk. Essentially, you’ve given up the opportunity to hit home runs for the benefit of never striking out.

With that out of the way, let’s talk about the risk of diversification.

Whenever you diversify, if you’ve done it correctly, there will always be something in your portfolio that you’re in love with and something that you want to dump (or will at least be the source of concern, as bonds are now in some circles). Some investment or asset class will be doing fantastic compared to the rest of your portfolio, and something will be doing much worse than everything else.

The trouble is, you never know when all of this will change. The thing you want to buy more of now will someday become the thing you want to sell.

But here is the point. The risk of diversification is that you will bail on it as a strategy at exactly the wrong time.

That feeling you get — the one that says, I wish I could dump this lame investment so I could buy a whole bunch more of this incredibly hot one — can get you into trouble fast. The temptation is greatest when it would be the most catastrophic for you to succumb.

But that feeling is actually telling you that you’ve done the right thing: You’re diversified. So remember that when the current fad ends and today’s rejects come back into style, you’ll be okay. And you’ll be awfully glad you didn’t give in to the temptation to give up on being diversified.

The next time diversification appears to not be working, remind yourself that it is a long-term strategy that can’t be judged on your short-term experience. In other words, just because something isn’t working right this minute — or even right this year — doesn’t mean it’s broken. So instead of thinking, “I am a rocket scientist and I can come up with something better,” just let diversification do its job.

Then go for a hike in the mountains instead of sitting hunched over the sell button on your broker’s Web site.”

 

Did he just say that Diversification was broken?

We’ve been starting to see more and more of this lately…. People eschewing diversification for the big returns from being fully invested in the stock market. Add that to the questionable investments lately (Football player’s success) and the margin debt at the NYSE moving into bubble territory, and it’s starting to look a bit frothy out there.

But let’s tackle the diversification is broken theme for a minute, articulated in a recent piece by John Authers titled “This is no time to get off the equity train.” The first paragraph lays it out there quite clear (emphasis ours).

 “At present, stock markets continue to charge uphill. That is good for those who are on board, but horrible for anyone who has gone out of their way to diversify. Diversification looks bad when it turns out you don’t need it.”

That’s a harmless enough statement in and of itself. A lifejacket looks silly when you don’t need it. A seatbelt is a little uncomfortable when you don’t need it. And insurance is expensive when you don’t need it. We couldn’t agree more. But Mr. Auther’s starts to take it in a bit of a different direction as he goes on with his piece, calling out a poster child for portfolio diversification and the heavy use of alternative investments: Yale’s endowment:

Yale University’s endowment, under the leadership of David Swensen, upended conventional thinking on diversification some two decades ago. Mr Swensen argued that he was most likely to find value away from the public markets. Private markets were more likely to be inefficiently priced, and therefore offer bargains. He moved out of bonds and cash, and into hedge funds, private equity and real assets such as forestry. Yale now holds about 6 per cent of its assets in US equities. This reaped impressive returns for decades, and many endowments imitated it.

But this diversification could not stop Yale from suffering a loss during the financial crisis period of 2008-09. Since then, the stock market boom has not flattered endowments.”

The logic here that having as little as 6% in equities “reaped impressive returns for decades” but then suffered a loss during the 2008-2009 period is somehow a bad thing is missing the forest for the trees,  in our opinion.

Yale’s endowment reported a 4.5% return in 2008, and a -24.6% in 2009, but those are Fiscal Years, ending in June 30 of each year. So the -24.6% loss in Fiscal Year 2009 was actually between July 2008 and June 2009, which is nearly exactly the height of the financial crisis, where the S&P 500 was down -28.4% over that period. Not sure about you, Mr. Authers, but we would much rather have that -24.6% versus the -28.4%. Oh, and there’s the little point worth mentioning that the 2009 loss followed 19 consecutive years of gains (when the S&P 500 had six annual losses over the same period).

Yale Endowment Performance

Source: Yale Endowment
(Disclaimer: Past performance is not necessarily indicative of future results)

Next up, the argument that the traditional 60% stocks/40% bonds split is better than full diversification.

“Figures for 2011-12, when stocks also fared well, are drab. Yale made 4.7 per cent, but the average US endowment dropped 0.3 per cent, while the S&P gained 5.5 per cent. A combination of 60 per cent in stocks and 40 per cent in bonds, which is the way most endowments managed their money before the Yale revolution, would have risen 6.3 per cent.”

We wouldn’t recommend investors base decisions on a single year, ever. One year does not make a track record. And if we look at the ten years, from Jan 2003 to present, the Yale Endowment would have a 117% total return, versus a 60/40 portfolio having a total return of 57%, (we used the S&P 500 at 60% for stocks, and the Barclay Bond Aggregate index for bonds at 40%).

Yale vs. 60 40 (1)(Disclaimer: Past performance is not necessarily indicative of future results)
(Disclaimer: Yale Endowment does not include this year’s returns)

Again, not sure about you, Mr. Authers, but +117% versus +57% shows us that diversification into more than just bonds is working quite well for Yale – to the tune of twice as well over the last 10 years.  But that may be what Authers is really getting at, as his closing lines talk about Yale’s returns being more about Swensen being early to the alternatives/private equity movement, versus their benefit as diversifiers, and that he is reducing the private equity exposure because of that:

“Mr Swensen himself is reducing his allocation to private equity. Many of his buys were a one-off opportunity – to buy assets when they were not understood and when skilled managers were available to take advantage of mispricings. That opportunity no longer exists. As “me-too” investors crowded in, markets grew more efficient and returns dwindled – but the wave of imitators did help push up Yale’s performance.”

That argument is a little over our pay grade (and research budget) – not being private equity folks – but we can argue that it is unfair to implicate all of the alternatives space based on that same logic. And to be fair, Authers isn’t implicating all alternatives – he seems to be just calling out private equity here, saying the opportunity for private equity to managers to “take advantage of mispricings” no longer exists. (a big claim with the billions and billions of dollars current in Private Equity – but he’ll have to defend that on his own).

And Authers does save himself from jumping on the ‘diversification isn’t needed’ crazy train in his conclusion, saying:

That does not mean that the case for diversification has vanished. Conditions like those of the past five years are unlikely to be repeated very often. But the case is not to buy what Yale bought two or three decades ago. Rather, it is to apply the same process, look for assets that may be inefficiently priced and would not fall with equities, and to buy those.

That process should still work when, as is inevitable, stocks at last lose their momentum.”

We can argue on his semantics there, in that it is more important to find asset classes with different return drivers (which leads to them not falling with equities) rather than assets which are inefficiently priced, but that may be splitting hairs – and at the end of the day we’re thankful he realizes the inevitability of stocks, “at last” losing their momentum.

 

Devil of a Dilemma: Add the Carry Trade to Trend Following?

We read a lot around these parts; it comes with the job, and we always like to come across well put together pieces from outside our offices, enter Eclipse‘s recent paper. It wouldn’t seem like the type of thing we would be into, titled: Combining Momentum and Carry Strategies Within a Foreign Exchange Portfolio.

For one, we’re not all that into ‘foreign exchange portfolios’ – seeing people get too carried away trying to get foreign exchange exposure without really understanding what that is or does. Anyway,  we liked how the paper starts off, with a nice little table highlighting the benefit of adding 20% managed futures exposure to a stock portfolio. (note it is through Mar. 2013, and still holds true, despite the poor environment managed futures has been in as of late).

BTOP SP500 compareSource: BarclayHedge
(Disclaimer: Past performance is not necessarily indicative of future results)

But the paper is more than just a managed futures advertorial, the paper is really about exploring the benefits of strategy level diversification, and on a more general level – combining a technical, systematic based model such as trend following/momentum, with a macro/fundamental strategy such as FX carry.

Ahhh, the old carry trade, often talked about but less frequently understood. Eclipse does a nice job of explaining just what the carry trade is, and why it is theoretically profitable.

“Carry is a simple, commonly used strategy in foreign exchange markets that involves buying currencies with higher yields and selling currencies with lower yields. One variation of this strategy can be easily accessed using Bloomberg’s Forward Rate Bias (or FX carry) function. The strategy, as we implemented it, ranks each currency based on that country’s 3-month deposit rate yield and takes long positions in the three highest yielding curren­cies and short positions in the three lowest yielding cur­rencies. Theoretically, as argued by Burnside, Eichenbaum, Kleshchelski and Rebelo (2011), the carry-trade bears fundamental economic risks and therefore should earn positive expected returns.”

They go into three different ways to weight a portfolio with momentum and carry, finding that equal weighting works the best. And, of course, combining the two together looks better than either do separately (we’ve yet to see any papers when the combined result is worse…) But the interesting thing to us wasn’t really how the combination performed. The interesting thing to us is seeing how the carry trade has performed over the past few years while the momentum trade has been struggling (we’ve added the down arrow to momentum since 2009 and upwards sloping arrow to the carry strategy).

Cumulative Daily FX Momuntum FX CarrySource: Eclipse Capital
(Disclaimer: Past performance is not necessarily indicative of future results)

This would explain the inclusion of the carry trade in quite a few ‘managed futures’ programs we’ve come across recently.  It’s hard to pass up that positive performance of late while the momentum strategy has been struggling, but beware the crisis period with too much carry trade exposure. Just check out 2008 for the carry trade up above – that’s quite the sell off. Indeed, Quest Partners piece from earlier this year showed that the largest managed futures programs (as represented by the BTop50) have become much more correlated to the FX Carry Trade, and warned that this may impact their performance to deliver crisis period performance in the future.

It’s a devil of a dilemma – add something to the portfolio that’s working now, but that may cause problems later… or forego what’s working now in order to maintain the purity of the crisis period performance profile later.  Or the third option – try and have it both ways, getting the good from the carry trade now, and timing its exit correctly when momentum comes back into vogue.

 

The ‘Problem’ with Liquid Alternatives – in one nice Table

Adding ‘alternatives’ to your portfolio has never been as easy as today with the plethora of so called ‘liquid alternatives’, or mutual funds specializing in alternative investments such as managed futures. And the marketers have never had such an easy time separating the naive from their money in their bids to raise money for these funds.

Enter an old five-pager by the Principal Group we just dug up which explains how to utilize 15 different hedge fund strategies in portfolio construction. It has all you would ever need to know about these highly complex investments, dedicating 4 to 6 sentences to each one! (are you picking up the sarcasm) For example, thinking about managed futures in your portfolio, here’s all you need to know:

 • Intended Effect on Portfolio =  Diversifier

 Definition = Commodity Trading Advisors (CTAs) trading commodity, currency, and financial futures typically using trend-following models and sometimes fundamental economic analysis.

• Expect to work best when = Should perform well in adverse market conditions for stocks and bonds.

• Expect to work worst when = Generally performs worst in markets that are directionless and have no lasting trends.

• Outlook = Positive outlook – Macroeconomics are dominating capital flows and valuations, which should provide good opportunities to these managers.

• Tracking Index = The HFRI Macro: Systematic Diversified Index includes strategies that have investment processes typically as a function of  mathematical, algorithmic, and technical models, with little or no influence of individuals over the portfolio positioning.

That’s all you need to know? So much for the Chartered Alternative Investment Analyst designation or decades of experience with the asset class. Just grab the nifty cheat sheet here and start building portfolios. Sure, there are some managed futures mutual funds which don’t even invest in managed futures. Yes, there are some which employ strategies that should not perform well in a crisis – but you understand the basics, and the funds say ‘managed futures’ on the label… what could go wrong?

What could go wrong indeed – how about mismatched performance with investor expectations, high fees,  poor relative performance to benchmarks, a concentration in the largest managers which deal mainly in financials, counterparty risk, credit risk, and the propensity of the correlations and relationships listed all blowing up during a crisis.

I guess we shouldn’t be surprised when FINRA put the responsibility on the investor, not the marketer of these products, to make sure they know what the product is doing. But still… this quick synopsis strikes us as all that is wrong with the mutual fund wrapper for alternatives, just glazing over reams of complexity with easily comprehensible talking points like the following from the piece:

[Alternatives Can…]

Enhance portfolio diversification. When alternative strategies are added to a traditional diversified portfolio of stocks, bonds, and cash, they may help investors achieve broader portfolio diversification as well as potentially create more efficient portfolios due to their expected low, or even negative, correlation with traditional assets.

• Produce consistent returns over time. Combining alternative strategies with traditional portfolios has the potential to generate attractive returns over time through a variety of market conditions.

• Preserve wealth over time. Because alternative investments seek low correlation with traditional assets, they may help to preserve wealth when stocks and bonds are out of favor.

Marketers, take note, this is how you sell a complex idea to unsophisticated investors. Unsophisticated Investors, take note, it’s a lot more complex than this!

 

Risk On/Risk Off Market Snapshot: June 2013

As we’ve been stating the past couple of months, the markets are on the move, and our monthly peek at the Risk On/Off stats provide a little bit of proof of that. We’re far off from the big moves of a year ago, but we’re definitely moving into more of a risk on/off environment than we were in at the turn of the year.  It is worth mentioning that June 20th saw an average move of -3.05% across the ‘Risk Off’ markets we track, the biggest move up or down of the year.

(Disclaimer: Past performance is not necessarily indicative to future results)

The 6-month moving average is hovering in the 5-7% range, below the 2002-2008 range (10% to 20%) and significantly below the typical levels from the last couple of years (20% to 35%) We define risk on as an average gain of over 1% for “risk” assets; risk off is an average loss of over -1% for “risk” assets. (Click here for a more detailed breakdown.)

 

Risk On/Risk Off Market Snapshot: May 2013

2013 continues to sport far fewer risk on/off days than the last few years, with only 2 days added to the tally in May: 1 risk off and 1 risk on. The big risk off drop on the first day of the month gave way to a risk on rebound the next day, with normal trading the rest of the month. Not even the broad selloff in stocks and metals at the end of the month was enough to qualify as a risk off day, as it was offset by gains in grains.

That brings the year to date total of risk on days to 4, and risk off days to 2, with all 6 of those days coming in April and May. The 6-month moving average is hovering in the 5-7% range, below the 2002-2008 range (10% to 20%) and significantly below the typical levels from the last couple of years (20% to 35%).

(Disclaimer: past performance is not necessarily indicative of future results.)

We define risk on as an average gain of over 1% for “risk” assets; risk off is an average loss of over -1% for “risk” assets. (Click here for a more detailed breakdown.) Prior to 2008, the yearly average of risk on/risk off days stayed between 10% to 20%. So far, 2013 has gone in a very different direction, with only 4.9% of days this year qualifying as “risk on” or “risk off.”