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Friday, July 22, 2016

What Drives Momentum Performance?

Mar Vista Investment Partners has a really interesting research piece out The Price You Pay which has a great table outlining the benefit of an asymmetric return profile (i.e. having more market exposure during up markets than down markets).

It is a mathematical truism that superior down capture in negative periods provides more capital for compounding in the ensuing positive periods. Using S&P 500® Index monthly total return data for the last thirty years, the chart below demonstrates the expansive value created by preserving capital in the down periods even with subpar returns in the positive periods. Each column shows the ending amount of capital with $100,000 invested in the S&P 500® Index over thirty and ten years with various combinations of monthly up and down capture.

As shown in the table above, even a 10% difference in up / down capture can provide a material impact to returns and the path of returns.

This also happens to explain why momentum works... with a traditional momentum model where you are in either stocks or cash, you will rarely capture 100% of the market's upside (the strategy is not always going to be in stocks when the market is up), but you will by the same math almost always improve the downside capture. The chart below shows the rolling three-year upside and downside capture figures for a basic momentum model and shows momentum often, but not always, provides favorably asymmetry (i.e. upside capture > downside capture). Over the longer-term (50 years), the upside has been 70% vs downside of 56%.

It is the low downside capture during market sell-offs that has driven the strong relative and absolute long-term performance of this momentum strategy. Again... while there have been many periods in which this momentum strategy has underperformed, over the longer-term it has slightly outperformed the S&P 500 since 1966 (10.2% vs. 9.7%) and with a much lower standard deviation (12.7% vs. 18.9%). The chart below shows the tight relationship between three-year excess performance and three-year upside minus downside capture, which points to why momentum strategies have largely underperformed since the 2008-09 correction when markets have generally moved higher.

The momentum investment opportunity becomes even more interesting if you can pair the above return stream with a strategy that may improve up capture during positive market environments, but I'll save that for another day.

Tuesday, July 19, 2016

Why Does Crime Feel Exponentially Higher, When It's Materially Lower?

Every day we hear about some new horrific event taking place globally. The common view is that crime is rampant and the United States is headed in the wrong direction. But that view is not supported by facts. In a Citylab article related to the recent level of crime, it was noted:

"The story is actually better than we all anticipated it would be," says John Roman, a senior fellow at the Urban Institute's Justice Policy Center. "Violence is down a little bit. Property crime is down a lot… and all of this suggests that crime in America is continuing to move in the right direction.”
Over the longer-term, the decline in violent crime is even more notable. Despite the United States 21% population increase since 1995, violent crimes were down -35%, translating into a decline in violent crime per capita of almost 50%. Rape, murder, and robbery were all down over this period in absolute terms and down a lot in per capita terms.

Source: FBI

Why Does it Feel Like Crime is Getting Worse?

My theory is the perceived increase is related to the way information flow has made the world a much smaller / more local place.

One exaggerated example: if 150 years ago you lived in a 500 person town and your local newspaper maybe covered news from a 10 town population of 5,000, the sample size for your local crimes was that 5,000 person population. With a violent crime rate of 1000 per 100,000 people, you might hear about 50 crimes per year (or about 1 a week). If the crime rate were to move lower, given the same population, the decline would be felt via the reduced number of headlines in the local paper (see example A below). However, if a new paper came to town sharing news from a much larger base population, despite a material decline in overall crime, the number of crimes being reported might spike to 1 per day (outlined in example B).

Our Local Community has Grown Exponentially

Recently, we haven't just experienced a small increase to the size of our local population (from a town to neighboring towns, to our state, or even to our country), but the entire world (or the entire universe if you really want to freak yourself out). In addition, when news flowed through print, it was limited by what could be reported by space (only so much paper) and timing (only news could be reported as of a certain time each day before it became old news). Now, the cycle is infinitely larger and continuous.

If I was scared of being attacked by a homeless man, there is news for that. If I was scared my children would be abducted, there is news for that. Hell... if I were scared of the dangers of Pokemon Go, there is plenty of news for that. When the world becomes your local neighborhood, a 50% decline in the violent crime rate over the last two decades still means there are tens or hundreds of thousands more opportunities each day to freak out (note the y-axis in the chart below is in log form because of the exponential nature).

This won't stop any time soon. People have evolved over thousands of years to seek out scary news and freak out about things we perceive can harm us. Combine this evolutionary characteristic with the for profit nature of news organizations (fear sells) and strawmen politicians build utilizing some randomly occuring event as "proof" it happens all the time and you have a recipe for disaster.

They key is to remember that if properly weighted, only a tiny fraction of news would be bad news. Just imagine the sentiment if it that was how the world was accurately perceived.

Friday, July 15, 2016

The Case for Avoiding Bonds During Disinflationary Environments

I made a short-term case for bonds in a recent post given my view that low rates may be disinflationary, despite my view that they have a "horrific risk / return profile" over the longer-term. This post will highlight that what matters over the longer term is the level of inflation over the entire life of the bond (rather than the current inflation rate).

To drive this point home, the chart below outlines the ten year realized real yield of a ten year treasury (the nominal starting yield less the inflation rate over the forward ten years), as well as the realized real yield assuming the current 1.6% yield was the starting yield over each of these periods (going back 140 years).

It may be surprising to learn that the real realized yield was above 0% (i.e. treasuries provided a positive real return for an investor) in ~75% of these rolling ten year periods vs ~25% if each period had a starting yield of 1.6% (those numbers are ~80% and 0% - not once - assuming rates had started at 1.6% over the last 50 years). What may be more surprising was that the best time to have purchased bonds historically was when there were higher levels of inflation present. The chart below outlines the historical (i.e. backward looking) ten year inflation rate (x-axis) against the forward ten year realized real yield (y-axis).

Why have bonds been a better buy when historical inflation was high and worse when historical inflation was low or negative?

Similar to how the market is currently pricing in record low yields given the view of low inflation over the next ten years (likely based upon the low inflation we have experienced over the most recent ten years), the market has historically repriced the yield of Treasuries much higher when we've experienced high levels of recent inflation. Thus, when inflation mean reverted higher from low levels / lower from high levels, the rates (in hindsight) did not properly reflect the forward inflation environment. If we were to look at the predictive power of 30 or 40 year bonds, the predictive power would be even worse (good luck with that 0% yielding Japanese Government Bond).

Thus, despite the low level of historical inflation, current (historically) low levels of nominal yield suggest that bonds are in fact likely as wretched a long-term investment as they seem.

Thursday, July 7, 2016

Global Bonds are a Speculative Investment / The Case for Bond Speculation

Back in 2010 I had a post titled On the Value of Treasuries, where I outlined the total return for Treasuries was potentially greater than the (at the time) 2.71% yield given the very steep curve. The summary was that if the yield curve didn't change over a one year horizon, the total return for an investor was closer to 4.2% (the 2.7% yield plus and additional 1.5% coming from the ten year Treasury rolling down from a 2.71% yield to the 2.54% yield of a nine year Treasury). Not a bad trade at that time.

A Whole New World

Fast forward to today and you have a very different situation. Not only is the yield on the current ten year Treasury about half that 2.7% yield (1.39% as of yesterday), but the yield curve is very flat (the nine year Treasury yield is only 4 bps lower (1.35% as of yesterday) as the back-end has been smushed (a technical term).

As a result, the roll down math (assuming the yield curve does not change) is as follows:

Current yield + change in yield x duration = 1.39% + 4 bps x ~9 years = 1.75% total return

The Resulting Risk / Reward Profile for Treasuries is Horrific

As I'll outline with some simple bond math, a lower yield and a limited roll benefit makes the case for Treasuries much more speculative in nature... either speculative that rates in the United States will continue to move towards or through 0% (we've seen it in places such as Japan, Germany, and Switzerland) or speculative that cash will continue to yield less than the current 1.39% for years to come.

What we do know with certainty is that bonds will provide a nominal return roughly equal to their yield over a period of time roughly equal to their duration. In the case of Treasuries, that means with certainty Treasuries will provide a cumulative return close to:
  • 10 Year Treasury: (1 + 1.39%)^9-1 = 13.2% over the next 9 years
  • 30 Year Treasury: (1 + 2.15%)^22-1 = 59.7% over the next 22 years 
That doesn't mean Treasuries won't provide an outsized return over the next year, but any return in excess of its yield is like squeezing blood out of a turnip limiting its future return potential. The chart below outlines the potential returns for the ten year Treasury following various levels of 12-month performance. This short-term return could, in theory, be 15%, but that would just mean forward returns for the remainder of the duration will be negative (again... the cumulative return cannot move away from that 13.2% figure).

The Risk / Reward Profile for Global Bonds are Even Worse

Japanese Government Bonds (JGBs) show how much juice has already been squeezed out of some global bonds. There is a 40 year JGB that started 2016 yielding 1.42%, which now yields just 0.08%. The below chart uses the same framework as the chart above, but for the 40 year JGB at the start the year.

The result is a monster 50% return year-to-date (even more in US dollar terms given the yen rally), but this comes not at the expense of most of the returns for the next 29 years... ALL of the return for the next 29 years. In other words, to invest in 40 year JGBs effectively yielding 0% you are speculating that yields will move further negative or that cash rates will remain negative (on average) for a period that may be close to (or longer than) the rest of your life.

The Case for Speculation / Low Rates May Be a Self-Fulfilling Prophecy

All of that said, the challenge in this current market is that while the risk / reward profile of global bonds is horrific, speculation of even lower rates may turn out to be self-fulfilling if ZIRP is not partnered with increased fiscal spending.

Why? Because the juice has effectively already been squeezed out of the turnip, meaning future returns in global bonds are gone. This "should" have provided a bump to the global economy and global inflation by taking all the returns (and consumption) and pulling it forward, but it has not.

Why? Perhaps these gains have accrued to institutions that own these bonds (central banks, insurance companies, pensions, etc...) that won't spend it / are already on the hook for liabilities in excess of their assets, while investors who already lack the belief forward stock returns will be near the 8-10% they have historically provided, now project their future interest income from their cash or bonds to be at or below 0%.

The result is the need for individuals to save MORE, not less, for retirement, for a house, for a car. With no institution (corporate, government, etc...) willing to spend this increased savings in the form of investment (which seems like a smart thing to do as the hurdle for a positive NPV project is effectively 0%), deflation becomes a much larger possibility... in turn creating the possibility of even lower rates.

Tuesday, July 5, 2016

How the NBA Destroyed League Parity by Increasing Compensation Parity

The Economist has an interesting article If You Can't Beat 'Em, Join 'Em on the NBA's disaster of a collective bargaining agreement "CBA" that has effectively ruined the chance of parity in the NBA, something it was meant to foster (hat tip Lawrence for the article) and set the stage for Kevin Durant joining the 73 win Golden State Warriors (note: I am a huge Warriors fan and still not happy that he left Oklahoma City from a basketball standpoint... though I am excited to watch Durant play more often).

Two of the main issues outlined:

1) Players are entitled to 51% of all basketball related revenue

Under the current CBA, the players are entitled to 51% of all basketball-related income. So when new money comes in, the team salary cap goes up—and when a lot of new money comes in, the cap goes up a lot.
2) The max any player can receive is capped (at roughly $24 million, depending on service time which I'll ignore)
That gave every team an extra $24m of cap space to sign whoever they pleased—an amount that just happens to be nearly as large as the individual maximum. 

What Does this Mean to the Compensation Structure of the NBA?

In simple terms... each team NEEDS to spend a certain amount of money (I say "needs" as the maximum amount each team can pay is likely below the clearing value if it were a free market) and the amount of money that can be paid to any individual player is capped. My guess is the result is players in aggregate make less, but that non-stars make much more (with the decrease being more than 100% compensated by the stars).

The below is a framework for my guess as to how players would be compensated with no collective bargaining agreement (i.e. a completely free market), with a cap of the current $94 million per team with no player cap, and the current cap of $94 million per team with each player being capped at ~$25 million / year (in the real world there are a lot of nuances in these numbers and they aren't meant to be exact).
  • No CBA: in a free market, teams will simply pay more for talent as a whole (which is what we saw before there were huge penalties invoked in the latest CBA to team's that paid more than their allotment), which would also allow rookies to make more than the limits the league has imposed. 
  • Team's (not players) capped: there has been a lot of research already pointing to stars being underpaid in the current structure due to the max contract each player can receive. Given only 5 players can play at any time and the fact that one player can turn a team from mediocre to the world champs (unlike in a sport such as football), true stars should make multiples more than anyone else and would likely receive the marginal dollar if an owner had to choose.
  • Team's capped + max player contract: if a player would have otherwise made more in % of a team's payroll in a capped structure, then by definition limiting these stars to a certain $$ amount would increase the amount all others could / need to receive. 
Throw in the additional detail that team salary levels spiked when current stars were already locked into below market rate contracts and you have all the ingredients you need for massive overpaying of below average players.

Back to the Economist with the impact...
The real lesson from Mr Durant’s decision is the same as the one provided by Mr James’s original move to Miami: that the NBA’s CBA is a train wreck. At the very least, the maximum contract needs to go—it reduces the entire art of team-building into a sycophantic exercise of courting superstars who cannot be paid what they are worth.
It should be no surprise that if you can't compensate a player much closer to what they are worth if they stay (or in other words... penalize a player more for leaving), they will be more likely to leave an existing team for other forms of compensation (including improved odds of a championship, a more ideal living location, friendship, other forms of compensation, etc...), all of which are more likely only at a handful of teams in the league... including Golden State.

Thursday, June 30, 2016

The Case for Momentum in Expensive Markets

Charlie Bilello, one of my favorite follows on Twitter, analyzed the relationship between market valuation and future returns (over various time horizons) in a recent post Valuation, Timing, and a Range of Outcomes. The post contained some very insightful tables, such as the one below, where he shows that valuations matter... if you pay less for stocks, you will generally be provided with higher returns (on average) over almost all time frames.

The Case for Momentum

In a previous post Valuations Do Matter (Even Over Shorter Time Frames) / Momentum Driven Valuation Timing, I highlighted a similar point and in addition took a look at how stocks performed at various valuation levels when 12-month returns had been positive or negative. The takeaway (highlighted in the table below) was that market returns were generally strong when stocks were:
  • Cheap (with positive or negative momentum)
  • Expensive with positive momentum

To bring this full circle, the tables below replicate Charlie's analysis, but also compares those results with the average forward return for a momentum strategy with the following rules (note the returns in the table below differ slightly from Charlie's - not sure what data he used, but I used data from Ibbotson's):
  • If the CAPE of the S&P 500 was within the bottom 50th percentile (which happens to be less than 17x), allocate to stocks; otherwise...
  • If the S&P composite had a one year backward looking return that was positive, allocate to stocks 
  • If the S&P composite had a one year backward looking return that was negative, allocate to cash (t-bills)
Click the table for a larger view

The case for trend following when markets are expensive becomes abundantly clear when viewed in chart form... when markets are cheap, an allocation to stocks resulted in returns that were on average exactly the same as a buy-and-hold strategy over the short-term and returns that were broadly in-line with those of a buy-and-hold over longer periods. When markets were stretched, momentum protected an investor from severe drawdowns over shorter periods and allowed returns to on average compound over longer periods.

At a current CAPE in the U.S. approaching a level that would put it in the top 10% of most expensive levels over this time frame, a momentum strategy may prove to be a good mechanism for investors to time exposure to an expensive U.S. market.

Monday, June 13, 2016

The Brutal Math of a 60/40 Portfolio

Think only a bear market can keep returns of a 60/40 near 0%... think again.

Given the huge opportunity cost of allocating to cash or bonds at current yield levels, even generally optimistic return assumptions for stocks are enough to keep portfolio level returns near 0% real. The goal of this post is to set the stage for a future post where I hope to share potential solutions that may improve potential returns with a similar risk profile as a traditional 60/40 and to set proper expectations of what a 60/40 allocation dragged down by low yields may provide.

After-tax real return forecasts (see below for the formula used in the calculation)

  • Let's say you assume stocks will return 6% nominal going forward. 
  • After tax returns (assuming gains are taxed at the more favorable 20% capital gains tax rate) = 4.8% (6% x [1 - 20%]) 
  • After tax after inflation returns assuming a forecasted 2% inflation rate = ~2.8% (4.8% - 2.0%) 

  • Bonds will generally (best case scenario) return their yield (current yield to worst of the Barclays Aggregate Bond index = 2.0%) 
  • After tax returns assuming the less favorable rate applied to coupons (and a 35% tax rate) = 1.4% (2% x [1 - 35%]) 
  • After tax after inflation returns assuming the forecasted 2% inflation rate = ~-0.6% (1.4% - 2.0%) 

  • 60% Stocks = 2.8% x 60% = 1.68% contribution 
  • 40% Bonds = -0.6% x 40% = -0.24% contribution 
  • Total return = 1.45% real 
Throw on the ~1% fees many financial advisors charge and/or the lower yields many investors are accepting by taking less duration risk / diversifying U.S. bond exposure to even lower yields abroad and an investor may break through the 0% threshold even with a 6% stock forecast. This coming from an allocation that has a historical standard deviation of roughly 10% over time.

Initial takeaways 

The math above outlines the importance of:
  • Shielding returns from taxes whenever possible 
  • Keeping fees as low as possible (or ensuring you get something for your fees)
  • Seeking alternative sources of return (whether through allocation or alternative asset classes that now have a very low hurdle rate relative to bonds to be included)
  • Minimizing an allocation to negative real return asset classes

Tuesday, May 17, 2016

Can We Predict Forward Alternative Investment Performance?

My friend Ben from A Wealth of Common Sense poses the interesting question, How Should Alternative Investments Be Benchmarked? Please go read his post for a number of interesting thoughts on that topic. In this post, rather than rehash his arguments, I'll go a different direction and articulate what drives the performance of alternatives (i.e. hedge funds / liquid alts) to see if we can predict forward performance (which in a backwards way, may provide some insight into how an investor might think about benchmarking performance).

Low Interest Rates = A Headwind for Absolute Hedge Fund Performance

What's interesting to me is that one of the main reasons I regularly hear why investors are allocating to hedge funds, is actually a reason why hedge fund performance has been so disappointing. Back to Ben's post for a specific example in the form of a comment from his reader (bold mine).

Interest rates are too low and stock market volatility is too high so we have to hold some alternatives in our client portfolios. 
Low interest rates are actually a reason not to own alternatives. People seem to forget that alpha is a "cash plus" return stream. The excess performance of a hedge fund (with 100% of returns driven by alpha) will be a certain %, which added to the cash rate gets to the total return generated by the hedge fund. The same skill that generated a 10% hedge fund return when cash rates were 5% (5% alpha + 5% cash), only generates 5% when cash rates are 0%. As a result, all else equal, the lower the cash rate, the lower the relative performance of hedge funds.

Predicting Alternative Investment Performance

While interest rates are an important consideration when making an allocation to an alternative manager, they are not enough to predict future relative performance vs a traditional stock / bond allocation. One key is to look at the level of risk premia (both stock and bond risk premia).

Risk premia is:
The difference between the expected return on a security or portfolio and the "riskless rate of interest".

In my analysis I calculate the expected return on stocks and bonds as follows:
  • Stocks: CAPE yield (1/CAPE) - Source
  • Bonds: Long Term Bond Yields - Source
I then subtract out the riskless rate of interest (which I define as the average 7 year forward t-bill yield) to get the premia, while the 40/60 blend is a 40% equity risk premium / 60% bond term premium blend (given the average hedge fund beta is ~0.40). In this analysis, I forecast future cash rates moving up 50 bps / year to 2% and staying there (more on this later) to get the stock and bond term premia for forward years that have not yet occurred.

In terms of predicting alternative fund vs. stock / bond performance, the opportunity cost of allocating to a hedge fund is largest when these premia are high and lowest when they are low (or negative). As you can clearly see from the chart above, stock and bond risk premia were very low in the late 1970's / early 1980's when cash rates were elevated, high in the mid 1980's when Volcker was able to control inflation pushing down cash rates, subdued in the 1990's when stock valuations got extended, then huge in the mid to late 2000's after the financial crisis that pushed stock valuations lower and cash rates to 0%.

Given the above framework, you can see how the mid 1990's were a great time to be in hedge funds from both an absolute perspective (cash rates were high) and relative perspective (the equity risk premium was low), while the exact opposite situation has been true for the last 7+ years. The chart below takes the above starting risk premia levels since 1994 and plots them against the relative forward performance of the Credit Suisse Hedge Fund Index (I can only get returns starting in 1994) vs. a 40% stock / 60% allocation.

What Can We Predict from Here?

Given this analysis, it appears the opportunity cost of hedge funds is once again approaching "fair value" given the much lower bond term premium, BUT an allocation will be largely dependent on an investors view of the direction of cash rates. It is less important to relative performance whether cash rates are currently low, but whether they will stay low. Should they move much higher than the 2% modeled in my analysis, then now may actually be a good time think about alternatives.

Sunday, May 15, 2016

The Smoother "PATH": PutWriting At The High

The analysis presented below combines two separate frameworks that were previously outlined:

The first post outlined how avoiding bear markets (by only holding equities when they were near an all-time high) has lead to very strong risk adjusted returns, going so far to show the great performance of a strategy that only allocated to stocks when they were at an all-time high. The second post outlined what an investment in put writing provided and pointed out the surprising fact that selling puts on the S&P 500 has actually resulted in better risk-adjusted returns when markets were calm than when volatility was heightened (and premiums were higher). I recommend reading either / both if interested in more detail.

When Does Put Writing Make Money?
Selling puts make money when the premium collected is greater than the decline in the market (relative to the strike price) from the time the puts were sold to the time the puts expire (i.e. ignoring financing costs if you sold an at-the-money put, collected a premium worth ~5% of the notional value of the S&P 500, and the S&P 500 went down less than 5%, the trade was profitable). Thus, despite the lower premiums collected, selling puts more consistently make money when market volatility is low because the market is much less likely to decline (i.e. selling insurance to safe drivers is more lucrative even if you charge a lower premium).

Going one step further, the chart below shows all forward one month returns for the CBOE PutWrite Index and the S&P 500 Index only for periods when the S&P 500 reached an all-time high the previous month-end going back 25 years.

Highlighting the consistency of returns for both the CBOE PutWrite Index and S&P 500 when the previous month-end value of the S&P 500 was at an all-time high:

CBOE PutWrite
  • 11.1% annualized geometric returns
  • 4.6% annualized standard deviation
  • 2.9% annualized downside deviation
  • Positive 79% of the time
S&P 500
  • 8.5% annualized geometric returns
  • 10.3% annualized standard deviation
  • 4.8% annualized downside deviation
  • positive 60% of the time

The PATH Model
The model below is a simplified / lower risk version of one I've kicked around for a while, but it has resulted in an interesting historical path of returns.

The rules:
  • If the S&P 500 ended the previous month at an all-time high, allocate to the CBOE PutWrite Index (PATH = Putwrite At The High)
  • Otherwise, allocate to Aggregate Bonds
  • Levered version = 2x levered allocation to the CBOE PutWrite Index at-the-high financed at the applicable cash rate

The caveats of how this will perform going forward should be pretty obvious, namely that the path of the S&P 500 is hugely important.
  • If there is no new S&P 500 high, the strategy will simply sit in bonds (and yields are much lower)
  • If there is a huge market downturn in the period that puts were sold, that loss may take a LONG time to make up (especially at low yields)
Caveats aside, the relative historical returns of the non-levered model were ~2% higher annualized than bonds with an almost identical risk to the index, while the 2x levered version provided returns that were "stock-like" (~4% higher than bonds), but with a 60% lower standard deviation and a 90% lower max drawdown than the S&P 500.

At some point in the likely distant future, I hope to put out a white paper with a much more in-depth background and details of the broader model. For now, please feel free to reach out to me with any thoughts on Twitter @econompic.

Wednesday, May 4, 2016

Growth or Value in a Low Growth Environment?

Financial Advisor Magazine recently published an article by the CIO of LPL titled 'Value Comeback' making the case for Value. There were some interesting points in the article connecting the recent growth outperformance with lower interest rates and/or oil, but the following point on low growth being a driver of the growth outperformance did not make much sense to me.

One of the main arguments against value (and in favor of growth) in recent years has been the slow global growth environment. When there is not a lot of growth in the economy or corporate profits, then it logically follows that the market would pay a premium for the companies that are generating growth (what we have referred to as motorboats, which can grow without a macro tailwind, as opposed to sailboats, which need economic growth to grow). 
The data support this. Over the past 25 years, when economic growth is slow (real gross domestic product [GDP] below 2.5%), growth outperforms value by an average of 4.1%, and beats value two-thirds of the time.
This caught my eye because in a previous post I noted that despite the outperformance of growth over the past 3, 5, and 10 years, it wasn't multiple related (i.e. investors have not paid a larger premium for growth stocks). In fact, growth stocks have gotten relatively cheap by the measure of forward P/E (the current premium is about 20% for growth vs. the 30 year average of ~40%). In addition, I always assumed that growth did better during strong periods of high growth because that's when optimism tends to be highest and growth stocks become bid up during that exuberance (i.e. the roaring 90's).

So I ran the numbers for the same period that was reflected in the article, looking at Russell 3000 Growth and Russell 3000 Value (all cap indices) as my growth and value proxies. I then annualized the performance for each quarter when real GDP was < 0%, between 0% and 2.5%, between 2.5% and 5.0%, and 5%+. The results show value has historically done better in all environments EXCEPT when growth was quite high (above 5%).

Much of the historical outperformance of value did coincide with much higher valuations for growth stocks, so past outperformance of value vs growth may not happen even if growth remains sluggish going forward. In addition, the depressed price of commodities (due to the global slowdown) may make value (where most energy companies are classified) as the place to be if the economy expands quickly, However, it does clearly show that economic growth has been good for stocks in general and high levels of economic growth have historically been especially good for growth stocks.

Friday, April 29, 2016

Know What You Own: Alternative Funds Edition (Streamlined)

For the full wonky version of the below, please go here.

Below are the objectives / investment strategies of two different “alternative” funds pulled from the prospectus and/or annual report for each, along with high level details of how they were actually positioned as of their most recent semi-annual reports on 12/31/15. In this post I'll leave historical performance out of it (one has been horrific, one has been solid - which makes sense when you realize they are opposing strategies), as this post is meant to highlight the importance of looking under the hood, only allocating to strategies that you understand, and ensuring that the manager follows what has been outlined in their prospectus. This is especially important when it comes to alternative funds with less defined limitations (though in the case of Fund A... they seem to simply ignore these limitations).


Fund A: 
  • The Fund seeks to achieve long-term capital appreciation, with added emphasis on the protection of capital during unfavorable market conditions (page 1).  
  • The total notional value of the Fund’s hedge positions is not expected to exceed the value of stocks owned by the Fund (page 3).
Fund B: 
  • "Always hedged, all the time, using put options" (source)
  • "With no reliance on market timing or stock selection" (source)
To summarize, Fund A states it it can not have negative market exposure, while Fund B is described as always being hedged to the market (i.e. implies a 0% market exposure).


The chart below is my attempt to simplify the payoff structure of each Fund inclusive of all the options they have bought or written (go here for a full breakdown of the fund positions). Fund A sold deep-in-the-money calls that effectively neutralized the stocks held, leaving only the puts (meaning it is short the market). Fund B is a bit more complex, but is long the market on the way up (though less than 100%) and exposed to the market (though less than 100%) on the way down (with a relatively neutral position when the market is down ~5-10%).

  • Fund A states it can not have market exposure of less than 0%, yet was materially short the market 
  • Fund B implies it is has 0% market exposure, yet was materially long the market
So the two funds basically have:
  • The exact opposite stated investment strategies as one another
  • The exact opposite positioning as one another
  • The exact opposite positioning as their own stated investment strategy
And we wonder why there is investor confusion / disappointment?

As an aside... I find Fund B's strategy interesting.

Know What You Own: Alternative Funds Edition

Warning... I got way too wonky in this post. If you want a streamlined version of the below, go here.

Below are the objectives / investment strategies of two different “alternative” funds pulled from the prospectus and/or annual report of each, along with detailed analysis of how they were actually positioned as of their most recent semi-annual reports on 12/31/15. In this post I'll leave their actual performance out of it (one has been horrific, one has been solid - which makes sense when you realize they are opposing strategies), as this post is meant to highlight the importance of looking under the hood, only allocating to strategies that you understand, and ensuring that the manager follows what has been outlined in their prospectus, This is especially important when it comes to alternative funds with less defined limitations (though in the case of Fund A... they seem to simply ignore these limitations).


Fund A: 
Objective: The Fund seeks to achieve long-term capital appreciation, with added emphasis on the protection of capital during unfavorable market conditions. It pursues this objective by investing primarily in common stocks, and uses hedging strategies to vary the exposure of the Fund to general market fluctuations (page 1).  
Investment strategy: The investment manager expects to intentionally “leverage” or increase the stock market exposure of the Fund in environments where the expected returns from market risk is believed to be high, and may reduce or “hedge” the exposure of the Fund to market fluctuations in environments where the expected return from market risk is believed to be unfavorable (page 3). 
To make it abundantly clear how this fund defines leverage and hedging, the prospectus states.
Leverage: "The maximum exposure of the Fund to stocks, either directly through purchases of stock or indirectly through option positions is not expected to exceed 150% of its net assets" (page 3). 
Hedging: "The total notional value of the Fund’s hedge positions is not expected to exceed the value of stocks owned by the Fund, so that the most defensive position expected by the Fund will be a “fully hedged” position in which the notional values of long and short exposures are of equal size" (page 3).

Fund B: 
Objective: The Fund seeks income and growth of capital (page 1).  
Investment strategy: "The Fund's core strategy has been and will always be to purchase an underlying hedge at 100% of the notional value of the underlying through corresponding LEAPS put options and proportionally write shorter-term options against the long underlying equity ETFs and LEAPS puts. Premiums received from writing options represent income-type positions that are designed to take advantage of time decay and help pay for the cost of the hedge"(page 2). 
Elsewhere, Fund B is described as:
  • "Always hedged, all the time, using put options" (source)
  • "With no reliance on market timing or stock selection" (source)

To summarize... fund A states the fund can have exposure ranging from 0% to 150% (i.e. cannot go short), while Fund B is described as always being hedged the the market (i.e. implies a 0% market exposure) and uses the time decay (i.e. they are long theta) to pay for the hedge.


While I hoped to stay out of the weeds with regards to option pricing, the tables below break down the fund exposures inclusive of the options bought or written as of 12/31/15. While funds often mark options at market value (i.e. how much you can buy or sell them at that day's close), economic exposure is what matters to an investor (i.e. if the market moves up or down, what is the impact to the portfolio). As an example, stock futures are marked-to-market every day, meaning they have a market value of ~$0 at the end of the day. Yet I think we can all agree that a fund with 3x notional exposure to stocks (i.e. triple levered ETFs) have 300% exposure to the stock market, not 0%.

To calculate the real exposure, you first need to calculate the notional exposure of the options and delta adjust them to account for how in or out of the money the options are (delta is the degree to which an option is exposed to shifts in the price of the underlying asset). Walking through the table columns from left to right...
  • Contracts: # held or written as of 12/31/15
  • Expiry: when the option contracts expire
  • Index Value: the value as of 12/31/15
  • Strike: the level at which the stock is in- or out-of-the money; puts are in-the-money when they are below the strike, calls when they are above
  • Notional: contracts x 100 (notional value of $100 times the index value per the terms of these option contracts)
  • Delta: the degree to which an option is exposed to shifts in the price of the underlying asset (a deep in the money call option has a delta of 1 meaning it provides the same exposure as the underlying stock market, while a negative sign indicates it is short that exposure which results from buying puts or selling calls); note I assumed an 18% volatility figure to calculate the options for all periods, which is right around where the VIX was as of 12/31/15 as is close enough for this.
  • Delta Adjusted Exposure: this is the economic exposure that investors are actually exposed to

Now let's take a look at what exposure the two funds had as of 12/31/15 (if anyone sees an issue with any of my calculations, please let me know).

Fund A (source)

Delta adjusted option exposure of -$900 million relative to the $600 million market value of the fund's stocks as of 12/31/15 = net -$300 million market exposure (i.e. it was 50% short the market as fund AUM was ~$600 million).

Fund B (source)

Delta adjusted option exposure of around -$500 million relative to the ~$1.27 billion market value of the fund's stocks as of 12/31/15 = net $777 million market exposure (i.e. it was ~60% long the market as fund AUM was ~$1.3 billion).

Long Option Exposure

Short Option Exposure / Net Fund Exposure

The chart below is my attempt to simplify the payoff structure of each, ignoring the time decay of options held (time decay is a huge drag on Fund A and a substantial tailwind for Fund B). Fund A sold deep-in-the-money calls that effectively neutralized the stocks held, leaving only the puts and a net short position. Fund B is a bit more complex, but is long the market on the way up (though less than 100%) and exposed to the market (though less than 100%) on the way down (with a relatively neutral position when the market is down ~5-10%).


  • Fund A, which states it can have market exposure between 0% to 150%, was materially short the market 
  • Fund B, which implies it is has 0% market exposure, was materially long the market
So the two funds basically have:
  • The exact opposite stated investment strategies as one another
  • The exact opposite positioning as one another
  • The exact opposite positioning as their own stated investment strategy
And we wonder why there is investor confusion / disappointment?

As an aside... I find Fund B's strategy interesting.

Tuesday, April 12, 2016

What You Pay Matters Less than What You're Paying For

Patrick O’Shaughnessy has a great post, The More Unique Your Portfolio, The Greater Its Potential, outlining how active share is what drives the level of potential before fee excess return for an active manager. If you allocate to active managers... go through it twice. As Patrick notes:

If there is a lot of overlap between your portfolio and the market, there is only so much alpha you can earn. This is obvious. Still, when you visualize this potential it sends a powerful message. Active share—the preferred measure of how different a portfolio is from its benchmark—is not a predictor of future performance, but it is a good indicator of any strategy’s potential excess return.
In other words, active share is an important metric as it shows what an investor is actually paying for (especially true now that the cost of beta is essentially zero). So, while an investor still needs to fully understand and believe in an active manager's philosophy, process, and discipline, the cost paid may be less important in isolation. What may be more important is the cost paid relative to what you are paying for.

You don't always get what you pay for

Using Morningstar Large Blend category data (the most plain vanilla of the plain vanilla), the below charts look at the relationship between fund expenses and active share for funds with active share > 20 to see what an investor is actually paying for. I narrowed the universe down further to funds benchmarked against the S&P 500 and then I did my best to strip out funds with style tilts (i.e. there were some growth, value, and dividend funds that fell in the category). One issue that remains is the below is screened by oldest share class to exclude duplicates, so there is some apples to oranges comparisons going on in terms of share class (though almost all of the funds are A share).

The first chart highlights the weak relationship between expenses charged and active share provided. An extreme example that was stripped out of the analysis that I came across was an S&P 500 index fund charging 1.60% with a 4.75% load.

The second chart compares the expense ratio against expenses normalized for active share (i.e. expenses charged divided by active share). Given the weak relationship between expenses and active share from the first chart, it should be no surprise that higher expenses generally mean higher normalized expenses too. This is a reason why funds with higher fees are less likely to outperform than funds with lower fees... investors are generally not getting a higher active share product for those higher costs.

Things get more interesting when you compare normalized expenses against active share. Here you can clearly see that the normalized expense ratio generally moves lower as active share increases. In fact, some of the cheapest normalized funds are those that have a much higher active share and may charge a slight premium.

Taking advantage of the "fungibility" of funds

While active share is a good indicator of a strategy's potential excess return gross of fees, an investor may not want to take as much relative risk or pay the fees embedded in the highest active share products. The good news is an investor can create a lower cost / lower active share solution through an allocation to higher active share managers and index funds... even if the cost may initially appear slightly higher in absolute terms.

For example... assuming an investor believes the capabilities of manager A and B are identical and has a 20% active share target. Yet:
  • Manager A costs 50 bps for 20% active share = 50/20 = 2.5 bp normalized expense ratio
  • Manager B costs 100 bps for 50% active share = 100/50 = 2.0 bp normalized expense ratio
While manger A is cheaper in terms of the absolute expense charged, manager B is clearly cheaper it terms of the expense per unit of active share. As a result, an investor can allocate 40% to manager B and 60% to a ~0 bps passive ETF, The result is the same 20% active share (40% allocation x 50% active share = 20% active share) at a lower cost (100 bps x 40% + 0 bps x 60% = 40 bps vs. the 50 bps for manager A).


When choosing an active manager, confidence in the team, the process, and the discipline the team has in following that process through various market cycles continues to be of obvious importance. As important is not the cost you pay in absolute terms, but rather what you pay for each unit of the skill they are selling.

Thursday, April 7, 2016

Active Management is Far From Dead

Eric Balchunas has an article on Bloomberg titled The Financial Industry Is Having Its Napster Moment asking "Has the music stopped for the financial industry?", sharing the following chart of flows since 2007.

He forecasts ~$1 trillion in outflows from higher fee active management every 4 to 5 years from here, which he believes will cause a material decline in revenue for investment management firms.
In other words, about $2.5 trillion in assets could migrate out of active mutual funds over the next decade. That money will shift from producing $18 billion in revenue to producing just $5 billion. That’s $13 billion less in revenue in the next decade and upward of $30 billion over the next 20 years. All this could be expedited by the new fiduciary standard—as well as a parallel trend that sees institutional funds moving toward passively managed investments, too.
As I'll outline below, while this is true in a vacuum... it misses an important aspect of what really drives asset growth (hint... for established players, it's not flows).

Flows Do Not Equal Asset Growth = The Industry is Still Thriving

Given this level of flows to passive from active, you would likely guess that the level of AUM for passive solutions would have grown by a much greater amount than active mutual funds, especially following the failure of active managers to protect investors during the financial crisis... right?


Given the huge AUM "advantage" of the much more mature mutual fund business, market appreciation has allowed domestic equity active managers to grow AUM by exactly the same amount within the domestic equity category, almost $1.8 trillion each since March 2009 market lows (data from Morningstar).

And while the Bloomberg article focused on domestic equities, let's take a look at the whole mutual fund / ETF complex..

That's a HUGE jump in AUM (and revenues) for investment management firms and given the huge operating leverage these managers employ (i.e. scale is huge for the bottom line) they are printing money.

So... unlike the music industry that has seen revenues slump as the preference for a high fee record slice has shifted to low fee digital, all while the overall music pie remains small (or has gotten smaller), the preference for a passive slice of the investment pie has occurred while that pizza has grown from a small to a large one.

If you believe capitalism isn't dead (I don't), then overall AUM in domestic equities (and especially across all global assets) will continue to expand... likely faster pace than active will be replaced.

Long live active management!

Monday, March 21, 2016

Buyback Performance Demystified

Earlier this month, in my post Stock Buybacks Demystified I attempted to remove some of the mystery surrounding buybacks, showing they are no different from an economic perspective (if you ignore the impact of taxes and the effects of signaling) than dividends. Given the recent outperformance of dividend paying stocks (as defined by those in the S&P 500 Dividend Aristocrat index) vs. stocks engaged in buybacks (as defined by those in the S&P 500 Buyback index) over the last year, I thought it might be helpful to demystify what has driven the recent outperformance of dividend stocks, share the historical performance of each, and outline some forward expectations for relative performance given where we currently sit.

Background: Buybacks have consistently outperformed since inception 

The first chart shows the growth of $1 invested in dividend stocks vs $1 invested in buyback stocks going back to the inception of the S&P 500 buyback index in early 1994. What we see is pretty consistent underperformance of dividend paying stocks over time that has compounded to 2% / year outperformance of the buyback stocks since inception (note both have outperformed the S&P 500). 

Background: Relative performance is highly mean-reverting
The second chart shows the relative performance of dividend stocks less buyback stocks over 12-month rolling periods going back to the inception of the S&P 500 buyback index. What we see is:
  • Pretty consistent underperformance of dividend paying stocks (most of the relative return series is negative) 
  • Mean-reversion characteristics (when one outperforms the other materially, it tends to bounce the other direction pretty quickly)
  • Dividend outperformance during periods of market stress 

Why have dividend stocks outperformed recently? Valuation differences
In addition to market stress that favors dividend stocks, the change in relative valuations have driven dividend stocks (i.e. it's been seemingly more technical than fundamental). The chart below shows valuations (i.e. P/E) of the dividend and buyback indices as of month-end February and as of a year ago. While dividend stocks were richer by this measure even a year ago, valuations among dividend stocks have held up pretty well. On the other hand, valuations among buyback stocks have gotten materially cheaper, driving the relative underperformance of buyback stocks and creating a huge valuation gap between the two. 

What now? 
The final chart shows the impact of shorter-term (12-month) relative performance between dividend and buyback indices on longer (3-year) forward relative performance. We can see:
  • Pretty consistent underperformance of dividend paying stocks over most three year periods 
  • Mean-reversion characteristics kicking in when dividend stocks have outperformed by the 10% level they have over the last 12-months (when dividend stocks have outperformed by 10% or more over a 12-month time frame, they have underperformed by an average of 6.4% / year for the next three years)

Neither dividend stocks or buyback stocks outperform in all periods or market environments, but under the view that the underlying economy appears to be holding up, current valuations, the historical outperformance of buyback stocks, the mean-reversion characteristics of buybacks (following recent dividend outperformance), and certainly the tax efficiency of buybacks all seem to support a tilt toward buybacks. 

Wednesday, March 9, 2016

Stock Buybacks Demystified

Based on my Twitter feed, stock buybacks seem broadly misunderstood in terms of what they are meant to accomplish (to redistribute excess capital back to shareholders) and the impact they have relative to dividends. As an aside, I also don't understand the following typical complaints:
  1. Buybacks are done when stocks are rich: if the stock of a company performing buybacks is "rich", then why are you owning it to begin with?
  2. Buybacks are often done during bull markets and stop during bear markets: that is due to the fact companies often have higher earnings and more excess cash available to distribute during bull markets

As a result, I wasn't too surprised when the below chart made the rounds yesterday, along with the following implications:
  • Stock performance is higher only because of financial engineering
  • Households are scared of equities and are poor market timers

In this post I'll provide the case for why (ignoring taxes and the effects of signaling):
  • Buybacks and dividends are economically identical
  • Buybacks are an incremental driver of the outflows we've seen from households
  • Why flows (both inflows and outflows) do not relate to demand / why households almost always have outflows

Buybacks and Dividends are Economically Identical

Excluding the potential signaling or tax effects of buybacks vs dividends, buybacks and dividends are identical in terms of overall economic impact. For example, assuming the following:
  • Corporation X has $2.5 billion in excess cash to distribute back to shareholders
  • Corporation X has a market cap of $5 billion ($2.5 billion enterprise value + $2.5 billion cash)
  • Corporation X has 100 million shares outstanding, priced at $50 / share (100 million shares x $50 / share = $5 billion market cap)
  • Corporation X will earn $1 billion ($10 / share) the following year
  • Shareholder X owns 100 shares and has spending needs of $1000
  • 100% of Shareholder X's wealth and income comes from their stock ownership

Situation 1: Corporation X distributes the excess cash to their shareholders via a $2.5 billion buyback
  • Corporation X buys back $2.5 billion of their shares at $50 (i.e. they retire 50 million shares)
  • Corporation X now has 50 million shares outstanding at $50 = $2.5 billion market value (all made up of their enterprise value)
  • With no dividend payment, shareholder X will need to sell 20 shares (x $50) to meet their $1000 spending need, meaning they will have 80 shares x $50 = $4000 in Company X stock
  • Corporation X will earn $1 billion next year or $20 / share given their 50 million shares
  • So... next year Shareholder X will be entitled to a $20 x 80 = $1600 of those earnings

Situation 2: Corporation X distributes the excess cash to their shareholders via a $2.5 billion dividend
  • Corporation X distributes $2.5 billion via dividend ($25 / share)
  • Corporation X still has 100 million shares outstanding, but at an enterprise value of $2.5 billion each share is now worth $25 / share
  • Shareholder X can meet all of their spending needs through the dividend distribution (1000 x $25 = $2500 dividends) and after spending $1000 still has $1500 cash remaining
  • Shareholder X can use the excess $1500 to buy 60 more shares at $25 share, meaning they now own 160 shares at $25 = $4000 in Company X stock
  • Corporation X will earn $1 billion next year, which is $10 / share given 100 million shares
  • year Shareholder X will be entitled to $10 x 160 shares = $1600 of those earnings

A table summarizing the above example (click for larger image)

What has changed? 
  • # of shares outstanding
  • Price of shares outstanding
  • Earnings per share
  • Shareholder X becomes a net seller of shares in the buyback scenario

What has stayed the same?
  • Enterprise value of the firm ($2.5 billion)
  • The overall level of earnings ($0.5 billion)
  • Earnings Shareholder X is entitled to next year ($1600)
  • Overall market value / demand for Company X stock from Shareholder X ($4000)
  • Overall net purchases of the stocks ($1.5 billion)*
* In the buyback scenario, $2.5 billion is bought back by Company X, but if all shareholders acted like Shareholder X, they would sell $1 billion for their spending needs ($1.5 billion net purchases); in the case of dividends, of the $2.5 billion distributed, $1 billion is spent, and the same $1.5 billion is used to buy back shares with the excess cash.

Household Flows Don't Matter / Should be Negative

As highlighted above under 'what has changed', household outflows are in fact impacted on the margin by the form of capital distribution (i.e. whether it is received via buyback or dividend). In the case of a buyback, households are simply creating their own dividend through the sale of shares. Given the two situations are identical in terms of overall demand for Company X stock (demand at time 0 was $5000 worth of stock, post spending it was $4000), we can see why flows really don't matter.

In fact, while the initial chart circulating through Twitter highlights the negative flows from the household sector for stocks from 2008-2015, what may be a surprise is that the overall level of stocks held by the household sector (i.e. a better measure of demand) jumped from $5.4 trillion at the end of 2008 to more than $12.7 trillion over that same time frame (as of 9/30/15  - the latest z.1 report), a normalized increase of 37% of GDP to 70% of GDP.

But a key point is that household net flows for a mature / functioning economy should be negative... when markets have positive returns, investors put in less money today than what that investment should compound to when they make withdrawals in the future. Thus, it should be no surprise that net flows from the household sector have historically been negative over all longer periods of time going back 60 years, while the amount of stock held by the household sector has continued to move higher.

To summarize... the form of distribution really does not matter and buybacks are not evil... the next time you hear someone state buybacks are the cause of the run up in stocks, try replacing the word buyback with dividend.

"Stocks are up because of a huge increase in dividends" sounds a lot less controversial than "stocks are up because of a huge increase in buybacks", though they are both identical signs that the performance has been driven by an improvement in fundamentals and an increase in cash flows.

Wednesday, February 17, 2016

Combining Momentum and Dollar Cost Averaging for Smoother Results

Josh Brown (i.e. The Reformed Broker) recently shared the aptly titled post How to Make Volatility Your Bitch highlighting how dollar cost averaging into a volatile market can lead to higher overall returns:

Door number one – you spend 15 years putting $1000 into an investment every month for 15 years, with the possibility of seeing that investment get cut in half twice.
Door number two – you spend 15 years putting $1000 into an investment every month for 15 years, with the same annual performance of what’s behind door number one, but no drawdowns.
Which would you choose? 
On the surface, you’d choose door number two. Of course, who wouldn’t? 
But it’s the wrong choice. The trick here is to remember that you’re adding to the investment at a rate of $1000 per month. That’s when you realize that door number one, with it’s twin 50% crashes, is the better option.
His point is an important one for long-term investors... you would rather pay less (than more) for a security today if it is worth more in the future and for long investment horizons that has typically been true. So in general, regularly contributing to your retirement (or other long-term goals) is good practice.

The Caveat

BUT there is a caveat... dollar weighted returns are only better than time weighted returns if the dollar weighted price you paid was lower than the price at the ending date. As dailyVest outlines (bold mine):
In contrast with a time-weighted approach, the dollar-weighted rate of return calculation method does measure the size and timing of cash flows, as well as the investment performance. Thus,
  1. Periods in which more monies are invested contribute more heavily to the overall return – hence the term “dollar-weighted” 
  2. In this case, investors are rewarded more for larger investments made during periods of greater price appreciation 
Given we are so close to the all-time high in the S&P 500, chances are each dollar invested over the last 15 years was below (or well below) the current price, resulting in more investments having greater price appreciation and dollar weighted returns > time weighted returns. So... rather than looking at just the current 15 year period, let's go back and look at 15 year periods ending 5 and 10 years back (which end at less of a peak) to see how well the same door number one vs door number two worked out.

Note: the analysis below shows $1000 invested each month in the S&P 500 and in a return stream with identical 15 year time weighted returns, but with 0% volatility.

Dollar weighted returns > Time Weighted Returns over Most Recent 15 Years

Dollar weighted returns < Time Weighted Returns over 15 Years Ending 2010

Dollar weighted returns < Time Weighted Returns over 15 Years Ending 2005

In these examples we see just how important the ending point is in determining which return stream "wins", as well as how important the end date is in the overall growth of the $180,000 contributed (which is a reason why investors generally should derisk as they approach retirement). It also outlines why dollar cost averaging into a solution that can protect against the downside may be beneficial relative to a buy and hold strategy by limiting the amount of dollar weighted contributions made at poor entry points.

Dollar Cost Averaging in a Capital Preservation Strategy: The Case for Momentum

Because I have the urge to compare all buy and hold strategies with momentum, the below replicates the above charts and adds a momentum equity curve with this simple rule at month-end:
  • If S&P 500 > 10-Month Moving Average, then S&P 500
  • Otherwise, Aggregate Bonds
Similar to what is shown in the charts above, the charts below outline the growth of $1000 a month into the S&P 500, an identical time weighted return series with zero volatility, and the above momentum strategy.

The momentum strategy provided much more consistent dollar growth in all three time frames and in these specific windows materially outperformed both a buy and hold and 0% volatility iteration (this will not necessarily be the case in all periods - especially in up and to the right equity markets). So... perhaps it's the combination of consistent contributions and a strategy more focused on capital preservation that can more easily make volatility your bitch (without the volatility).

Wednesday, February 10, 2016

Avoiding Bear Markets to Improve Risk-Adjusted Returns

Ben Carlson of A Wealth of Common Sense has a recent post, When Global Stocks Go On Sale, outlining that it is typically a pretty good time to be buying when the MSCI World stock index is in a 20% or greater drawdown.

His insightful takeaway and chart outlining the historical drawdowns and forward performance of the index is below:

There were only two times out of the ten bear markets where stocks weren’t higher one year later. Only once were stocks down three years later. And there was never a period where stocks weren’t higher five years after initially falling 20%. The paradox of investing is that the best times to put your money to work are often when things seem like they’re never going to get better.

While I in no way disagree with his insight, especially for a buy and hold investor thinking of selling, I thought it would be fun to share the completely opposing strategy that avoids these periods of distress, as well as one that avoids stock exposure after even one month of negative performance.

Avoiding Extended Drawdowns May Improve Risk Adjusted Returns

As I outlined in a previous post, Using "Normal" Drawdowns as a Timing Signal, an investor who sold their S&P 500 allocation whenever the S&P 500 index was in a drawdown of 10% or more, and instead held bonds, had similar long-term returns as a buy and hold investor, but with materially less risk and drawdowns.

A similar situation has played out for investors allocated to stocks within the MSCI World index when drawdowns were less than 10% or U.S. treasuries when the MSCI World was in a drawdown greater than 10%, while a 20% threshold wouldn't have held up quite as well as the 10%, but would have provided roughly similar returns with less risk than a buy and hold investment.

What gives?

The reason for the improved risk-adjusted performance has been the power of momentum within the MSCI World index during drawdowns. When the MSCI World index ended a month at a roughly 10% drawdown, it often moved lower... sometimes much lower. At a 20% drawdown, only 2 of the 5 times was this in itself a decent short-term buying opportunity (highlighted in green). The other 3 times presented a better opportunity further down the road.

Buying Only at the Peak

Taking this "drawdown avoidance" to the extreme, let's see how an investor in the MSCI World index would have performed if they only bought when it was making new end-of-month highs. In this example, an investor is only holding the MSCI World index if the previous month was at an all-time high, otherwise U.S. Treasuries.

While there were long periods of relative underperformance (and this is an extremely high turnover strategy), the resulting performance and lower risk offers some insight into how a strategy that is less exposed to risk, yet can avoid loss of capital, may actually be able to improve absolute and relative performance.