Will Simple Beat Complex in the Next 5 Years?

One of our favorite bloggers almost made us cry yesterday…  It’s Barry Ritholtz, formerly of The Big Picture Blog, but now plying his wares at Bloomberg – who grabbed the charts out of our own post on various markets movements and asset classes both before and after March 9th, 2009 (the equity low), and used them to kick managed futures while they’re down – claiming that because stocks beat (past tense) managed futures and hedge funds since the low, Cheap and Simple beats (present tense) Expensive and Complex.

“…the take away to a real-estate-owning-asset-allocator-stock-jockey like me is this: If you have a long enough timeline — a decade or more — simple beats complex, and low cost trumps expensive. Land and equities are likely to be the investments whose returns surpass everything else — assuming you start buying when you are young enough and at advantageous valuations.”

Suffice it to say that wasn’t the angle we were looking at… but let’s look at the data.

There’s no denying Barry Ritholtz is one of the most well respected voices in all of the financial blogosphere. We’re frequent readers of his blog, and enjoy his commentary most of the time, with the occasional exception (Sorry, Barry, Commodities Ain’t Managed Futures). And on the base level it sure looks like Barry has a point, with the ‘simple’ investments of stocks and real estate having beaten the complex investments of managed futures and hedge funds handily since the March 9, 2009 low, and even over the 10 year period starting March 9th, 2004, which includes the huge drawdown periods of stocks and real estate. The current run up in stocks has cured a lot of ills, to be sure.

But what if we push the look back another 5 years, to March 9th of 1999? It’s once again a different story, with the complex investments now back atop the scoreboard ahead of “simple” stocks, although “simple” real estate was a very high flier. Here’s the three five year periods in a row:

Last 5 Years (simple wins)

March 2009 20145 Years Before That (complex wins)

March 2004 - March 20095 Years Before That (a mixed bag)

March 1999 2004(Disclaimer: Past performance is not necessarily indicative of future results.)
Sources: Managed Futures = Newedge CTA Index (* = Data begins in Jan 2000),
Bonds = S&P/CitiGroup International Treasury Bond Ex-U.S. Index
Hedge Funds= Dow Jones Credit Suisse
Commodities = UBS Commodity Index (DJC)
Real Estate = iShares DJ Real Estate ETF (IYR) (* = Data begins Jun 2000)
World Stocks = MSCI ACWI ex US Index, US Stocks = SPDR S&P 500 ETF (SPY)

Of course, Barry could push the goal posts back yet another 5 years, where stocks would include their internet bubble run up and once again move to the top of the scoreboard, proving if nothing else that you probably don’t want to be looking at the best performers of the past 5 years for clues on where to put your money for the best chance of success over the next 5 years. No matter how simple or complex they are, these rankings and the resulting performance are highly volatile.

Which brings us to a little thing called risk. I’m sure we could get Barry to agree that it’s not always about returns. Whether you’re simple or complex, how much risk you’re exposing yourself to over the time span of the investment can really matter (it can be the difference between selling out of equities at the ’09 low versus remaining in). What if instead of looking at just returns, we consider the risk adjusted returns of the various asset classes, using the Sortino ratio (a fancier version of the more well known, but flawed Sharpe ratio) which measures returns over the volatility of the investment; and the MAR ratio, which measures return over the maximum risk of the investment (or worst peak to valley loss, known as the drawdown).

Sortino and MAR(Disclaimer: Past performance is not necessarily indicative of future results)

Adding risk into the equation pushes “complex” hedge funds up to the top of the scoreboard and “simple” real estate heads towards the bottom of the list, while stocks and managed futures are essentially equal – swapping places depending on which risk metric you use. {past performance is not necessarily indicative of future results}.  Turns out it isn’t as easy to say simple beats complex when incorporating risk into the equation.  From a risk perspective, bonds and commodities are really the standout; bonds for their high ranking and commodities for their negative ratios (meaning they’ve had a negative return over the past 10 years).

And while we’re on the subject of commodities, we don’t necessarily agree with Barry’s conclusion that one should have expected a greater return out of managed futures due to commodity rallies.

“The best performers leading up to the lows were managed futures and hedge funds. We’ve addressed hedge fund under-performance before. Surprisingly, despite screaming rallies in the 2000s in oil, food, gold and other commodities, managed futures only rose 26 percent during that five-year period. Given the 400 percent rally in gold, and the 500 percent in oil, one would have expected a greater return for this investment category.”

When we run the numbers, Oil didn’t provide a 500% return in that same time period, and neither did gold show a 400% return. Here’s how those commodities did if we line up the return mentioned by Barry with the same 5 year period (March 9th, 2004 – March 9th, 2009), with the commodity index itself actually down over that time, not screaming higher.

Commodity Exposure 2004 2009(Disclaimer: past performance is not necessarily indicative of future results)
Sources: Managed Futures = Newedge CTA Index, Commodities = UBS Commodity Index (DJC)
Corn, Crude, & Cold = Cash data from CSI.

Now, Barry did say the “screaming rallies in the 2000’s“, not the five year period before march lows, and if we look at just the rallies themselves, from 2000 to the high point of each, we see Crude up 469% and Gold up 317% at their highs. These were huge moves to be sure – but they didn’t come without a lot of risk, with each market seeing down moves of -78.85% and -12.74% from those highs during the financial crisis. And what about that commodity index itself, which was down over the period while managed futures was up.  Saying managed futures should have been up more when commodities overall were down, because Oil was up big; is a little like saying an investment advisor should be up when the overall stock market is down because Netflix was up 300%.  Diversification cuts both ways… whether in a stock portfolio or managed futures portfolio, intentionally dampening return in exchange for also dampening risk.

Finally, there’s the issue of the costs involved with the complex asset classes. We can’t argue that they are more expensive than “cheap” index investing via ETFs, but that’s hardly unique. “Simple” stock and bond mutual funds are also orders of magnitude more expensive. The real issue when it comes to cost is to make sure the structure and way you access the “complex” managed futures and hedge fund assets classes isn’t more expensive than it should be, which we tackled in this Bloomberg piece and would love to sit down and talk through with Ritholtz Wealth Management (which we suggested 5 better names for upon its launch).

At the end of the day, there’s no denying stocks magical run the past 5 years, but it pays to remember the high degree of risk and potential loss those gains were built off of, for it’s only a matter of when, not if, they will return. All in all, we’ll agree that simple has beaten (past tense) complex this round; but wouldn’t bet on a repeat performance in the next round. In fact, we would love to make a friendly wager with Mr. Ritholtz that managed futures will outperform stocks over the coming five year period. Barry, you up for it?

The Sterling Ratio Explained

RiskSitting here five years from the March 2009 lows in the stock market, it can be easy to forget just what makes alternative investments appealing for many investors. It isn’t the top line performance such as we’ve seen in stocks recently, more often than not it’s the risk adjusted performance.

The most popular (and overused) risk adjusted performance metric is the Sharpe Ratio, but the investment world is littered with many more of these tools for comparing different investments and asset classes to one another on how much return they earn per unit of risk. The risk part is what changes in these metrics, with the Sharpe seeing risk as volatility, the Sortino as downside volatility, or the MAR by maximum drawdown.

Enter the Sterling Ratio, which measures return over average drawdown, versus the more commonly used max drawdown – which is the largest peak to valley loss experienced over the entire track record.  While the Max Drawdown looks back over the entire period you’re analyzing and takes the worst point along that equity curve, a quick change of the look back allows one to see what the worst peak to valley loss was for each calendar year as well. From there, we can average the drawdowns of each year to come up with an Average Annual Drawdown.

Sterling Ratio = (Compound ROR) / ABS(Avg. Ann DD – 10%)

Some versions of the Sterling may also subtract the risk free rate (although it has been effectively 0% for the past 5 years, making it a moot point); giving investors a ratio of the average annual return over the average annual drawdown (less that 10%).  Ideally that number would be greater than 1, so you are getting more reward for the risk taken each year, and the higher the better.

Now what the heck is that arbitrary -10% in there for?  It’s sometimes listed as a positive number, too?  Let’s first say, the result of the equation should be a positive number, so if you are putting in your drawdown as a negative number, then subtract the 10%, and then multiply the whole thing by a negative to result in a positive ratio. If putting the drawdown in as a positive number, then add 10% and your result is the same positive ratio.

There’s not much documentation on why the 10% is in there, or even what the original definition of the Sterling Ratio is – but our take is that the average drawdown over a typical 5 year period can be quite small (just look at stocks the past 5 years), and therefore a sort of ‘reality adjustment’ is needed. Another possibility may be that the ratio would break (divide by zero error) if there were no drawdowns over the period, so the formula included the arbitrary number to insure there was always something in the denominator.

A better ratio would have a ‘reality adjustment’ factor tied to the program’s volatility or some other sort of metric based on the program’s data instead of just picking 10% out of thin air. Imagine program’s which target drawdowns of less than 10% don’t like that number much, as it increases the risk denominator for them 150% or more, while a -30% drawdown program is only looking at a 33% increase.

So there you have it, another risk adjusted performance metric for your toolbox, although given the vagaries of that 10% and ability of programs to mask their true risk profile over short periods of time, we prefer to look at the MAR and the all time max drawdown instead of the average.

For more on those equations, here’s a list of posts on the other ratios:

Sharpe Ratio explained

Sortino Ratio explained

Sortino Ratio Part 2

Mar and CalMar Ratios

Ulcer Ratio

Book Review: Fortune’s Formula

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.

Corzine at Fault… Again (We Know!)

Another missive on MF Global that we can drop straight into the “things we already knew” file: a new report from trustee Louis Freeh alleges that Jon Corzine was largely responsible for the downfall of the company. Not exactly shocking material, and quite a bit of it is simply a re-hash of other reports on the subject, but it does contribute to the mountains of damning evidence against Corzine.

Although none of the reports thus far have gone so far as to allege criminal misconduct for the “honorable” Mr. Corzine, it’s quite clear at this point that his hands-on approach and penchant for big trades were too much for a firm that lacked even the most basic of risk controls. From the report:

When Corzine’s vision was implemented, the Company’s deficiencies were exposed in a number of ways:

(1) there was no efficient, concise way for anyone at the Company to have an accurate and complete real-time snapshot of the Company’s most basic financial information, including liquidity;

(2) inefficient and outdated control systems were inundated as trading increased, crippling the settlement and clearing of trades, which became a decisive threat to MFGI’s ability to function during the last week of October 2011; and

(3) the inability to forecast and track financial information accurately on a real-time basis resulted in executive management reacting too late and too slowly to the growing liquidity pressures placed on the Company by the Euro RTMs and Corzine’s new trading desks.

As early as May 2010, Corzine and Steenkamp knew that MF Global’s control architecture was flawed. Gaps between approved risk and control policies and current practices were documented, distributed to management, and presented to the Board. Repeated warnings about the Company’s control systems put management on notice that the Company did not have the appropriate systems in place to support the expanded trading Corzine envisioned when he joined the Company.

Much of it is a recap of information that has already been outlined in previous reports, but you can check out some of the reactions to the report here and here. Coincidentally, Judge Glenn of the Manhattan Bankruptcy Court approved a final liquidation plan for MF Global Holdings today, confirming that the vast majority of customer money will be recouped. Corzine getting the blame (although sadly no jail time) and customers getting most of their money back… all things considered, not the worst ending to this tale we could have imagined back in October 2011.

Even if news like this doesn’t put Corzine behind bars, it will certainly aid the civil case against him. Of course Corzine’s defenders (yes, they exist) dismiss these autopsies as “Monday morning quarterbacking,” and like to point out that if MF Global hadn’t been sunk by margin calls and liquidity problems, those bit bets on European debt would have paid off. But that’s the rub – “I would have been right” doesn’t count for much, and even less so when you bankrupt a company and risk other people’s money with your recklessness.

A Mountain from a Mediterranean Molehill

You could be forgiven for thinking that the last few economic/financial “crises” haven’t felt very crisis-like. The dreaded sequester came and went without causing so much as a hiccup, and even the Italian election fiasco proved insufficient for more than a minor stumble in the market’s trajectory. But Europe seems intent on maintaining their new annual tradition of stirring up investor anxiety every spring. Enter: Cyprus.

Cyprus may be bigger than a molehill, but not by much. The fact that this much digital ink is being spilled worrying about a country with a GDP the size of mid-sized US city shows just how far we have to reach to find something dire to talk about these days. The country’s entire economy is a rounding error compared to the US federal budget…

Nevertheless, the airwaves are filled with concern that this could spark contagion, reignite the European debt crisis, and so on and so forth. Next verse, same as the first. At the end of the day, Cyprus matters precisely as much as people believe it matters, regardless of how much we think it ought to. And that means the possibility of choppy markets that have been the bane of many CTAs over the last several years.

But amidst the noise, we were pleased to see someone else who shared our frame of mind on such matters:

If you’re a trend follower like me, well this is one of those times when you need to be all over your risk management, because events like this have a habit of reversing or rapidly accelerating existing trends, so you need to stay alert for stops, and let your winners run until you get your exit. Stay focused. Despite the drama, this market is still in a solid uptrend.

Don’t expect this to die down quickly either. Right now the market doesn’t like this. If the vote doesn’t pass it will be a relief, but then that will put the entire aid package in jeopardy and then we’ll be back to the whole news cycle of waiting to hear it’s solved before we can move on. The media loves that stuff. Don’t be a slave to it.

The fact is, you have no edge trading off of news from Cyprus. You only have your system, your strategy, your process, your discipline. Stick with it. Follow whatever it gives you. Ignore the noise. Don’t watch TV. Watch price.

Sound advice in our book. Whatever comes of Cyprus, some prognosticators will be correct and some will be incorrect. But the traders with a sound system and solid risk management will be ready to capture a big trend if it arrives, or cut losses short if it doesn’t. Whether Cyprus causes just another ripple in the ocean or the tidal wave that the bears have been predicting for years – we’ll be glad we have our seat belt fastened.