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.

Persistence in investment manager performance – can he/she keep it up?

We’re now in year 7 of an equity bull-market; those patient and/or lucky enough to have bought the S&P 500 early-March 2009 are now up about 200% on their capital invested.  Each year, since 2009, seems to be the same story of ‘death of hedge funds…long live cheap equity ETFs’.  Linked to this idea is the underlying concept of performance persistence – how likely is good performance observed in past indicative of future performance?  Before shrugging off the previous question with the ubiquitous ‘Past performance is not indicative of future returns’, let me make a few observations on persistence, some of which are likely different from what you’ve come to expect:

  1. Persistence as link to risk premia: suppose we have an underlying risk which is investable – e.g. economic growth, inflation, credit worth.  If the underlying risk remains (e.g. the economy continues to grow), while folks remain uncertain about the extent and timing of the risk (e.g. some believe the economy is about to crash, versus others who believe it will continue growing), we should reasonably expect persistence in the risk premium over the very long run.  Solution: invest in risk exposures (‘betas’) for the very long run, e.g. long equity ETFs.
  2. Persistence among long-only asset managers: suppose we’re considering buying equities; now we wonder whether to put all long-equity investment into basic ETFs, or give some to long-only managers.  After all, several guys seem to have done very well, relative to the broad market, so can’t we pick well?  The answer is generally no, you are very unlikely to pick a long-only manager well.  In several studies – including this one – long-only manager skill is shown to have near zero persistence.  That means, while it’s possible to choose the rockstar manager for a short period of time, over the long-run you’ll likely end up with mediocre or worse returns versus the benchmark.  Solution: stick with pure index ETFs for long-only exposure.
  3. Persistence among alternative asset managers: now suppose you’re looking at alternative strategies, such as hedge funds, managed futures or private equity.  In contrast with #2, there is persistence in alternative manager alpha (e.g. see here).  With many hedge fund sectors, the best relative performers in the past remain so in future.  Solution: assuming everyone is accepting new capital, feel free to use historical track record relative to peers, when choosing alternative asset managers.
  4. What am I not saying? I’m not characterising persistence here as something magic – e.g. a 10% gain last year implies a 10% gain this year, or something like that.  Persistence mainly revolves around the very long term, with the noisiness of markets wiping out observed persistence over short time spans.  So the ‘Past performance … ‘ statement is absolutely correct in that, for example, we shouldn’t expect performance from fixed income long-only funds to be anywhere near as strong as in the past; the market conditions just aren’t there right now.  However, the underlying risk premium which fixed income funds exploit isn’t likely going away in the long term; there will likely be more gains to come for these funds.

In sum: keep those long-only ETFs as a basic exposure to (persistent) risk premia.  Don’t bother with rockstar long-only asset managers… you’ll likely be disappointed in the end.  Past (relative) performance for alternative asset managers seems to have more persistence, so feel free to use historical track records as a data point when considering these guys.

Hail to the quants…

I’ve written before about the merits of systematic trading…indeed I do a bit myself, in addition to investing with some quant shops.  Anyway, looks like they had a better year in 2014 than most stock pickers.  Congrats to those who have been long-term patient with the momentum traders – as expected/hoped/implicit in momentum strategies, years of lacklustre performance (e.g. 2009-2013) were more than compensated by 2014’s returns for a great many funds.

This leads to both Q & A:

  • A: I distinct recall speaking with many existing/potential investors in managed futures/systematic trading, in which the question was asked: is momentum dead?  Are the systems broken?  Hopefully 2014 helps answer that.
  • Q: is the performance of 2014 sustainable?  For example, 2008 was a great year for the strategy, with a bad year in 2009.  So will 2015 be like 2009?  I wish I knew, but for the moment I’m staying invested.

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.

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

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.

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

Again, let’s focus on a concrete example:

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

Cutting volatility through diversification.  Source: Quandl.

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.

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.

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

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.

      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.

      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.

The end of financial advisors?

I was interested to read a review of Betterment in one of my favourite money/savings blogs, The Simple Dollar.  Clearly early days for the reviewer, but the concept of Betterment (along with other robo-advisors) is fascinating to me.  As this technology becomes more ubiquitous, and average investor age approaches the tech-savvy generations, I think conventional financial advisors could well be innovated out of business.

Suppose you’re getting started with investing, and wondering how to get started.  As mentioned in my earlier Finance 101 post, choosing a financial advisor is a difficult (and ultimately unnecessary) step.  From my travels to many offices of financial advisors, I note a few general themes – with no offence intended for any particular advisor:

  • An advisor’s knowledge base is generally no better than a reader of the WSJ or FT.  Portfolio management, securities recommendations, etc., are generally passed down from a centralised function in a head office.  The advisor just assigns his clients to one or another ‘model portfolio’.  Thus, if you had access to his portfolio models, you could just bypass the advisor.
  • Advisors don’t generally outperform benchmarks.  Again, this follows from the fact most advisors fill clients’ portfolios with benchmark-tracking securities.  It’s a matter of career risk: if the advisor deviated from S&P 500 returns (or 60/40 returns, or some other common benchmark) and outperformed, he would keep his clients.  If he under performs through deviating, he’ll lose his clients.  If he performs at-or-around the benchmark, he’ll keep his clients.  So advisors tend to be very conservative in deviating from the model, which generally tracks common benchmarks.  Add in the extra fees for the advisor (and for the guys in the head office), and you’ll almost certainly underperform their benchmarks in the long-term.  Aside: an honourable mention to those advisors I have met who view themselves as long-term asset class allocators, rather than security selection experts; they do tend to outperform benchmarks through tactical allocation to asset classes (such as alternatives) that really do help.
  • The best reason to have an advisor: handcuffs.  Advisors have a great psychological role, particularly for folks who have very little knowledge of financial markets, and very little desire to learn about the swings of security prices.  Essentially the advisor becomes the ‘face’ of the financial markets for his client: when markets crash, he’s a bad guy; when markets rise, he’s a hero.  Most importantly, the advisor keeps the client invested during these swings (handcuffs).

There’s very little of the above that can’t be addressed by a service like Betterment.  In particular:

  • Ease of use.  Seems to me the service utilises sensible allocations (although just equity/bonds, see below) that require very little understanding of the user.  Great for folks with money to invest, but clueless how to begin.
  • Instruments used = cheap ETFs.  So tracking error to the benchmarks will be minimal.  They use least-cost ETFs to implement their ‘model portfolios’.
  • Quasi-handcuffs.  I say quasi, as it’s likely easier to liquidate your portfolio in tough markets with a group like Betterment than with an advisor.  The advisor will also actively attempt to dissuade you, whereas the customer service team at Betterment might not be as forceful.  But overall, the idea of sending your money away to be managed helps the client stay removed from the daily ups and downs that may cause distress and poor decisions.
  • Costs = low.  The absolutely most-insane part of financial advisory is the ridiculous fees advisors receive for using certain products.  So, on top of paying (say) 1-1.5% of AUM p.a. to the advisor, he may allocate your portfolio towards products that pay him an extra rate – I’ve seen trailing commissions between 0.25% – 2.5% of AUM p.a. for advisors.  The ETFs used by Betterment average about 0.2%, and their fee ranges from 0.15% – 0.35%.  You’ll be way better off, from a cost perspective.

OK, where could Betterment get better?

  • More diversification in the portfolio.  The model portfolios allocate between equities and bonds.  There are a lot more inexpensive ETFs out there, which access asset classes/strategies that bring better portfolio risk/return characteristics.  For example, they’re very much attuned to the value anomaly (they allocate specifically to value equity ETFs), but not to the momentum anomaly.  I imagine the portfolio options will expand someday.
  • Tactical allocation.  In particular, I don’t agree with the idea that bond ETFs are universally lower-risk than equity ETFs.  Especially with yields this low.  I don’t see info on the Betterment website whether their model portfolios take yield levels (or indeed, earnings yields for stocks) into account when allocating.
  • Risk of over reliance on Modern Portfolio Theory.  It’s a bit technical, but using MPT for portfolio allocations has a couple major downsides: unstable allocations and corner solutions.  Betterment writes they use Black-Litterman (BL), combined with some downside-protection approach.  I like this, but BL in particular can let in a lot of manager view: on the plus side, this would allow (for example) a view that bonds are likely to under perform in future; on the minus side, too much shading the market consensus (or that expected returns are equal to some constant) means more divergence from benchmark results.  Are you looking for truly active management?  I’m not sure.

In sum, I’m excited to hear how Betterment and the like grow over time.  For tech-savvy generations, and particularly those with NO desire to learn about markets, I’m much more in favour of this type of investing than conventional advisors.  I think they’ll gradually put financial advisors out of business, or at least cut their fees substantially.