Makin’ it blow: investing in renewable energy

Old school renewable energy. Source: Google Images.

I’ve written before about one of my main principles of portfolio management: diversification.  Very important, as I come to this investment game with much humility regarding my ability to forecast asset returns.  Choosing many different return streams should *hopefully* give the family portfolio the best chance at steady, but appreciable, gains.

The latest iteration of this approach finds me looking at renewable energy; in particular, corporate bonds secured on renewable energy infrastructure such as solar panels, biomass power plants or wind turbines.  Here are a few websites I came across while researching the space:

• Aegis Power
• Abundance Generation
• Investor Square

Some thoughts:

• Returns seem decent-high: most projects offer 6-10% p.a. interest, with tenors of 5-10 years.  Way better than the ~2%ish on government debt, or ~3.5% on corporate debt.
• Bond security seems decent: in the docs I’ve seen, the asset (e.g. a windmill) is pledged as security for the bonds.  So more security than you get with the debt mentioned above.
• Key risk is government risk: the economics of renewable energy are still tightly bound to government subsidies of various sorts.  In the UK (the focus of my research) the overarching EU scheme forces countries to generate ~30% of power through renewables by 2020.  The UK, for one, is nowhere near this.  So the government has rolled out several programmes to ensure those building renewable infrastructure get a guaranteed revenue stream.  BUT – as my dad always says, the only risk you can’t hedge is government risk.  In this case, suppose way more windmills get built than can possibly be used – would the government still provide the subsidies, particularly when some/all of these subsidies are paid through consumers’ energy bills?
• Other risks seem mostly insured/hedged: these include construction insurance, operating insurance, power purchase agreements, etc.
• In sum: the juicy return is in return for government risk.  If subsidies get slashed, with no grandfathering, you (as bondholder) end up with a windmill which generates uneconomic power.

Will I invest?  Given the timeline for most of these subsidies/schemes/agreements/quotas measure decades, it might be worth a punt for 5-10 years.  By then, we’ll likely either have far too much renewable energy than we know what to do with (not, in itself, a bad thing) or maintain status quo of needing more (with associated subsidies).

Hedge funds: haters gonna hate

Much in recent press arguing against hedge funds.  Probably related to news of another large pension fund divesting completely.  Plenty of vitriol around; a good summary of why not to invest in HFs from Barry Ritholtz is here, which further sources material from FT regarding ‘zombie funds’.

Let me highlight a couple reasons I’m still happy to invest in hedge funds:

1. Problem with averages + performance persistence = opportunities.  I recently wrote about how alternative asset managers (including HFs) show much more persistence in returns, unlike conventional asset managers.  Thus, as often thrown in as a throwaway comment in the articles above, there are managers out there which consistently beat the averages to provide attractive returns.  Unlike picking the best-performing long-only equity manager, hedge fund managers tend to show more consistent outperformance.
2. Risk premium diversification, at needed risk level.  Though most articles focus on how not diversifying hedge funds are as a group (probably because HF indices tend to have a massive overweight towards Long/Short equity and credit, which have high correlations to long-only equity), there remain several investment strategies which provide true diversification (e.g. managed futures/CTA).  Though some of these diversifying strategies are available in more conventional form – e.g. through an ETF or mutual fund – I appreciate the additional capital efficiency provided by higher-risk versions in ‘proper’ hedge funds.  More of a barbell approach to alternative investments (an aside – here is a new paper by Nassim Taleb et al. regarding mathematical justification for a barbell approach).

In sum: hedge funds can be massive wastes of fees, particularly if their performance starts to look very much like long-only equity.  However, even a small bit of due diligence can yield solid managers with solid track records in solid diversifying strategies.

Ignore John Bogle???

I was reading this Marketwatch piece this morning, and find the topic quite interesting. There is plenty of opinion out there that equal-weighted indices outperform market cap-weighted indices.  And when you look at RSP versus SPY, you indeed see the result.

Why would you choose RSP over SPY?

1. Why index? The conventional reason folks choose stock indices (especially broad-market indices, such as SPY) is to diversify away specific company risk.  We know that holding equity should pay a return in the long run; we just don’t want to get unlucky choosing a bad equity.  So we invest in everything, looking to average returns.  RSP, by investing equal amounts in each of the S&P 500 constituents, has more diversification than SPY.
2. What about rebalancing? The recent article by Campbell Harvey et al. is instructive here.  It turns out that regular rebalancing increases risk versus keeping a static portfolio.  So perhaps RSP pays more than SPY because it’s taking the extra risk.  Indeed, this is reflected by RSP’s 1.11 beta versus SPY: the former takes roughly 11% more risk than the same $ investment in SPY.  At least for the past year, the return of RSP has been about 1.11x SPY, so I guess the risk/return level is about commensurate.  Anyway, I could just suggest buying more SPY than buying RSP.
3. What about momentum? See the same article.  SPY, like other market cap-weighted indices, implicitly take a momentum approach to the market. Because there is no rebalancing in SPY, the fund will automatically allocate more capital to stocks with higher returns (and thus higher market cap).  Given momentum is a lasting source of return, you’re essentially getting a trading strategy for free in choosing SPY over RSP.

So what to choose? If capital were no issue, I’d probably just buy more SPY than going smaller in RSP.  I like the lower management fees (yes, I do agree with John/Jack Bogle on that point), and appreciate the implied momentum returns of SPY.  If capital were an issue, I’d think of RSP like IWM: a way to achieve higher returns for the capital than SPY, mainly due to overweighting smaller companies.

Round 3: winning the mental battle against volatility using managed futures

In the previous posts (here and here) I have illustrated a couple approaches to one of the most dangerous parts of personal investing: the mental anguish caused by volatile (equity) markets.  It’s one of the main reasons we as retail investors tend to buy high and sell low: it’s tough to watch the big oscillations that an equity portfolio experiences.

So far I’ve shown a very easy-to-implement solution (the ostrich method) and a somewhat easy approach (a leveraged investment in bonds).  Today I’ll talk about another method, which is adding an uncorrelated strategy to the equity portfolio: managed futures.

I’ve written about managed futures before.  In a nutshell, the strategies employed by these funds tend to be momentum-related, and therefore exhibit near-zero correlation with equities.  That’s about as good as diversification gets.  Let’s take a look at the managed futures index (the Barclay BTOP50) versus the S&P500 since 1997:

Better diversification = better portfolio. Source: Quandl and BarclayHedge.

A few observations:

• The performance of managed futures does indeed occur at different times than stocks.  There seems to be a toss-up whether managed futures will make money when stocks are gaining value
• A 60/40 mix of stocks and managed futures looks like better value portfolio diversification than 60/40 stocks and (unlevered) bonds.  This is due to managed futures having 3 beneficial characteristics versus bonds in the period:
  • Better returns (5% p.a. versus 1% p.a.)
  • Correlation to stocks closer to zero (-0.17 versus -0.27)
  • Volatility – and thus ‘diversification bang for the buck’ – higher (8% p.a. versus 5% p.a.)
• The 60/40 mix of stocks and managed futures seems a lot less ‘equity-like’ than the 60/40 stocks and bonds mix.  That’s the impact of the strategy diversification

So we can see that, when a material part of the portfolio is moved from equities to managed futures, the result is a better risk and return tradeoff.

Extension: let’s consider the same approach as last post, which used futures or similar to create a Triple 5-Year Note.  It turns out that a common practice among managed futures providers is targeted volatility, so we can in effect choose the amount of volatility we would like our investment in managed futures to have.  Some managers keep low volatility (e.g. 5-10% p.a.), whereas others have quite high volatility (e.g. 25-30% p.a.).  Let’s look at the effect of this on the equity/managed futures portfolio:

Higher volatility of diversifier = better diversification. Source: Quandl and BarclayHedge

We can see:

• The blue line remains the S&P500
• The purple line is the 60/40 mix of stocks and managed futures
• The green and red lines are different mixes of stocks and a theoretical managed futures manager achieving 3x the risk and return of the index (I am aware of managers who have achieved this, but I don’t think their track records are public)
• In order to make the 60/40 mix of equity and 3x managed futures seem sensible, I’ve switched to a log scale on the chart
• Two conclusions to note:
  • With the higher volatility, the 60/40 mix has pretty amazing performance, which doesn’t resemble equity very much.  So stocks have essentially become the diversifier, even though they’re a larger proportion of capital.
  • A higher volatility managed futures program means you need less capital invested to get the same diversification benefits.  In this case, switching from 60/40 to, say, 85/15 gives about the same diversification as the old managed futures case with better performance.

In sum: adding a diversifying strategy to the equity portfolio improves risk-adjusted performance quite a bit.  If you’re looking for ‘bang for the buck’, a high-volatility managed futures program should allow for a smaller capital allocation while maintaining diversification benefits.  And that should allow for less portfolio volatility overall, which helps win the mental battle.

Round 2: winning the mental battle against volatility using….volatility.

Last post addressed one way to deal with the mental anguish provided by market volatility: the ostrich method.  It’s a simple method, albeit not particularly sophisticated.  Also, the ostrich method doesn’t really help improve portfolio performance, aside from keeping the investor away from rash trading decisions.

So let’s try another way; let’s consider using market volatility as a weapon of choice against market volatility.  Let’s see how more volatility can help our portfolio weather the markets.

To conquer volatility, you must become…oh never mind. Source: Google Images.

Again, let’s focus on a concrete example:

• Another typical portfolio:
  • 60% long equities.  Proxied by S&P 500 index futures
  • 40% long bonds.  Proxied by US Treasury 5-year note futures
  • Portfolio start = Sep 1997 (earliest available data for 5-year treasury)
  • No rebalancing.  Just set and forget

And the data, with monthly views.  I’ve included a 100% equity portfolio for comparison:

Cutting volatility through diversification. Source: Quandl.

A couple observations:

1. Wow, what a run from stocks since 2008
2. Even with 60/40 portfolio balance, the portfolio looks a lot like the 100% equity portfolio.  How much diversification am I really getting?

OK, so we can show that diversification generally works to lower portfolio volatility (from about 16% p.a. with all stocks, to about 10% p.a. with 60/40 blend).  Returns are a bit lower, but risk-adjusted return is a bit higher.  What I’m not so happy with is the following:

1. My portfolio still looks very equity-like, even with 60/40
2. This diversification is expensive: I’m sacrificing about 1.2% returns p.a. for the peace of mind coming with diversification

How to solve this?  Here’s one idea: suppose I created a new portfolio holding called Triple 5-year Note.  This holding is exactly the same as the 5-year note in the example, but has 3 times the return stream.  That means 3x the risk and 3x the return.  For those familiar with futures markets, this is absolutely trivial to create (provided account size is large enough to overcome lot size issues, but I digress).

Let’s now add a 3rd portfolio to the arsenal, which is 60% stocks and 40% Triple 5-year Note:

More vol = better portfolio. Source: Quandl.

A few observations:

1. The new portfolio is a bit less equity-like.  In particular, I note smoother performance around the tech bubble, and better performance around 2008
2. Diversification is cheaper.  I only sacrificed 0.8% returns p.a. for my diversification
3. The new portfolio looks less volatile than the others.  And it is: portfolio volatility is 9%, rather than 10% or 16% in the older case

So what have we done?  We’ve lowered portfolio volatility and increased returns over the old 60/40 by increasing volatility of the diversifying asset.  The 5-year note future’s volatility is about 5% p.a., which is roughly 1/3 equity volatility.  By increasing the 5-year volatility to equal that of equities, we get more diversification.  That leads to better portfolio returns, and lower portfolio risk.

Extension: some may recognise this idea as a basic concept behind products such as Risk Parity or Managed Futures strategies.  In a nutshell, the strategies equalise each asset’s volatility in the portfolio, then weight each (volatility-scaled) asset such that diversification is maximised.

How to implement: I can think of a few ways to fight portfolio volatility through this method:

1. Use futures/options – if your account is large enough (e.g. 1 E-mini S&P Future has a notional value of around $100,000, and 1 5-year note future has a notional value of about $120,000), use futures as a replacement for long stocks/bonds.  You can easily create the Triple 5-year through buying 3x the note futures.  Smaller accounts can use option strategies, such as buying deep ITM calls or vertical spreads.  NB: you’ll need to roll these derivatives each month to maintain exposure.
2. Use leveraged ETFs – for example, TYD is a 3x-levered ETF on 7-10 year US Treasuries.  It’s very illiquid, so be careful.  Vol drag might be an issue, but probably not very (volatility is low, and carry is positive).
3. Buy a mutual fund – for example, AQR has a well-known Risk Parity mutual fund which uses similar techniques as noted above.  It would mean having only this fund in the portfolio, rather than in addition to other holdings.  But it’s an easy solution.

Next time, I’ll talk about managing portfolio volatility through adding managed futures.  In particular, what adding a small allocation to the strategy, and the effect of lower/higher volatility programmes, do for portfolio performance.

Winning the mental battle against volatility – the ostrich method

I’m planning to write a few entries on a topic close to my heart (insert jokes about how I need a real life here): portfolio volatility.  To begin, let me propose an old-fashioned technique for fighting the mental anguish associated with market volatility: the ostrich method.

A keen user of the ostrich method. Source: Google Images.

Let me explain with a concrete example:

• A somewhat-typical portfolio: 
  • 50% long equities.  Proxied by the S&P 500 index
  • 30% long bonds.  Proxied by the performance of a US Treasury Bond ETF
  • 20% long commodities.  Proxied by the performance of DB Commodities ETF
  • Portfolio start = Feb 2006 (start date of commodities ETF)
  • No rebalancing.  Just set and forget

Let’s look at the data.  All return series are rescaled to begin at 100:

Portfolio performance view Feb 2006 – Nov 2014. Source: Quandl

A couple observations:

1. Nice performance.  What we all know by this point: buy and hold (if you kept through the crash of 2008) worked just fine.
2. Lots of squiggles.  That’s volatility for you.  Not just the big swings (e.g. portfolio value going from 120 -> 80 in the crash), but the regular gyrations in the market.  Look at the recent sell-off in equities at the right edge: that was indeed cringe-worthy.
3. (aside) Long commodities don’t look very good.  I’ve talked about this at length in previous posts.

Now for the ostrich method of combating market volatility.  It’s simple to explain, by devilishly difficult to enact:

• Overall theory: returns for market risk premia generally oscillate, but are positive in the long term.  Thus, if we censor intermediate observations, we can focus more on the long-term drift than the interim fluctuations.
• In plain speak: markets rise and fall a lot, but generally rise over time.  For long-term investors, it makes sense to generally ignore market prices until a decision needs to be made (e.g. rebalance or sell holdings).
• Example: Using the same portfolio shown above, let’s take a look at a couple more charts.
  • Monthly looks: suppose you just look at your monthly brokerage statement, and forget about financial headlines/news.  Here’s how your portfolio growth would look.  As an aside, look how the recent equity sell off has “disappeared” from the chart…

  • 

    Same portfolio, using monthly data. Source: Quandl.

  • Yearly looks: suppose you just look at your annual review of your account.  Here’s how the portfolio growth would look.  Notice how smooth everything looks!

  • 

    Same portfolio, using yearly close data. Source: Quandl.

In sum, and probably flogging a dead horse here: long-term investors shouldn’t care about the newspapers/financial news/websites/etc., at least insofar as making portfolio adjustments.  Diversification works, when given time.

Next time I’ll write how volatility is a very useful thing.  Sometimes we might want more, not less, volatility in our portfolios.

Latest addition to the portfolio: peer to peer lending

In the never-ending quest for diversification (hopefully with a decent return), I’ve moved towards one of the newer asset classes out there: peer to peer lending.

The idea seems simple enough, yet quite possibly very risky and not as diversifying as some (OK, caveats completed).  Most personal loans are made by banks (duh), who have been cutting back on credit since 2008.  There’s a good reason for that – they massively overextended, due to low rates and competitive pressures – so seems a good reason to not lend to any and everyone.  However there’s a bad reason for that – the voluminous new rules (e.g. Dodd-Frank) which have led to much worse risk-weighting of bank assets.  That means not as much lending supply to those who are *probably* good credits.

Enter P2P.  Here’s the way I think of it:

• The good scenario: someone working in a cyclical industry (e.g. construction) had a tough time during the downturn.  Maybe went delinquent on a credit card bill a few times.  Didn’t declare bankruptcy, and managed to get back to paying on time.  However, now his credit score is too low for the banks to touch him when he wants to consolidate debt.  He wants to consolidate his credit card bills into one (amortising) loan with a 3 or 5-year maturity.  His interest rate goes from 20% or so to around 15% or so.  I’d probably take this credit.
• The bad scenario: someone unemployed, or newly employed, wants to redo his house.  Hasn’t had credit before, and wants a loan that is a high % of his income.  I don’t like these odds because of the unknown.

Anyway, I’ve chosen Prosper to begin the P2P adventure.  The site has been around quite a while, and looks to have good returns on seasoned loans.  I like the $25/loan minimum, which means I can diversify my credit risk pretty widely.  The loan listings are fun to peruse – I get to see plenty of borrower info, loan terms, etc.  And when I’m done allocating to loads of loans, I plan to use the automated investing feature and/or the API (NB: as these loans are amortising, you have to keep lending to ensure you keep generating returns).

In sum, I’m trying this out with a small amount of capital.  Hopefully the returns I get are similar to the overall market – e.g. much better than bank accounts and corporate bonds, but with likely credit risk similar or worse than high-yield corporate bonds.  It’s ultimately a bet on US recovery or status quo; even a well-diversified pool of loans will get smashed in a 2008 scenario.