Thursday, July 3, 2014

How to Analyze Smart Beta

Smart Beta (or whatever you want to call it) is the hottest new trend on Wall Street.  On the whole I think it is a great idea as there is no rule that market cap weighted indices are the best way to go.  However, whenever you see a flood of new products most are probably going to be more hype than anything else, so how do you evaluate this stuff?

Past performance doesn't predict future results, this applies to Smart Beta also.  No new strategy is going to be launched without a backtest showing that the strategy beats its relevant index.  There are some things you would want to pay attention to on any backtested returns:

1. Are the returns too good?  There are two ways to backtest, you can take a premise that should work going forward and see how it would have worked in the past---the right way.  Or, you can use your knowledge about what happened in the past to construct an awesome backtest---the wrong way.  If the returns are too good there is a chance the sponsor used his 20/20 hindsight to come up with the strategy.

2. What are the drawdowns vs. the benchmark.  Past performance is fairly meaningless for the future but past risk has some predicative ability for future risk.  Take a look at the drawdowns and calculate the MAR ratio (average annual return/maximum drawdown).  The strategy might have outperformed the benchmark but did it have a better MAR?

3. Do the past returns match the strategy?  For example if it is a lower volatility strategy what were the backtested results in 2008?  Should have been better than the benchmark.  If it is a high return strategy it should have done better than the benchmark in rally years.

Obviously what a strategy will  do in the future is much more important than what it did in the past.  You can't predict this but you can determine if the premise makes sense.  For example, there has been a lot written about factor tilts.  Small cap stocks have shown outperformance vs. the S&P 500.  If we assume that the market is up more often than it is down and when we are in a "risk on" type of environment then riskier stuff should outperform, then it makes sense that small caps will outperform large caps (albeit with more risk).  Value is another factor that has shown outperformance.  Going forward it makes sense that if you buy solid stocks when they are undervalued then you should perform better over time (albeit with some underperformance during speculative bubbles). 

On the other hand, there has also been research showing that low volatility stocks outperform.  This one doesn't make as much sense to me as lower volatility stocks shouldn't do as well during a bull market and I doubt that they can protect that much during a 2008 type of scenario.

Friday, February 7, 2014

What You Can Learn From Blackjack

Anyone who plays Blackjack at a casino understand that there are certain rules, that if you follow them, will get the odds close to 50/50 between you and the casino.  If you don't follow the rules then the odds tilt in the casino's favor.  Following or not following the rules doesn't guarantee that you will win or lose but it gives you the highest odds of winning, which will play out over the long term.

There is a more advanced move in Blackjack called surrender.  If you choose to surrender you lose half of your bet.  You would only use this move in a situation where the odds were strong that you will lose your entire bet.  Only losing half preserves your money for later when hands come up where the odds are in your favor.  So in effect, when you surrender,  you are guaranteed to lose half of your bet with no chance of losing your entire bet.  Will this move always work out?  Of course not.  But again the idea is to put the odds in your favor long term and preserve your capital for better opportunities.

I recently got an email from someone we work with who has a bunch of very risky mutual funds that have surrender charges.  He wanted to know whether it made sense to surrender these funds and pay a known surrender charge or hold them and hope the market came back.  I have no idea where the market will go from here but as I write this we are in a downtrend.  The odds are that it will go lower and that these funds will lose much more than the surrender charge.  Could he sell the funds, pay the surrender charges, and then the funds appreciate?  Of course they could.  Does that make surrendering them the wrong decision?  No, because it puts the odds of success in your favor and over the long term, if you do that, you will be much better off.

Monday, January 13, 2014

What You Know About Retirement Investing Is Wrong

This was the title of an article in the Wall Street Journal this morning:

Before you read the article what you knew about retirement investing was wrong.  After reading the article it is still wrong.  Instead of slowly moving your portfolio into more bonds as you progress into retirement (which makes no sense unless bonds continue the 30 year bull market they have been in, and even if they do makes no sense because the market doesn't care how old you are or how conservative you should be), the article recommends starting off retirement in more bonds and slowly adding stocks.
The success or failure of this approach has nothing to do with whether it makes sense or not, it doesn't, but what the market does over your retirement.   If the market cooperates then the approach could appear to work, just like Modern Portfolio Theory appears to work when the market is going up, if the market doesn't cooperate then you need to find a job when you are 80.

Since the market doesn't care how old you are or how conservative you are, and since we can't expect that bonds will always be in a bull market, the best approach is to stay in harmony with market trends.

Sunday, January 5, 2014

How To Invest as Interest Rates Rise? Keep It Simple Stupid

I just read a real long article in the Wall Street Journal with all sorts of strategies for investors who are expecting a rise in interest rates.  Some of the recommendations:

1. Sell high income sectors like utilities and telecom and buy sectors that can increase earnings
2. Stay away from Treasuries and MBS and look for beaten down munis
3. Resist the temptation to load up on short term debt
4. Lean towards economically sensitive sectors---consumer discretionary, energy, and financials
5. Watch out for emerging stocks and bonds
6. Be careful of commodities
7. Use a bond barbell to have a portfolio duration of 4-5 years

Investors could take a ton of time to dissect all this advice and try to create a portfolio that follows it to the letter, or they could just look where the momentum is and follow market trends and not worry whether rates are going up or going down.

Monday, December 30, 2013

Deep Risk

William Bernstein just wrote a book called "Deep Risk: How History Informs Portfolio Design".  I haven't read the book but in the January issue of Financial Planning magazine there is an article talking through the concepts.  Bernstein defines deep risk a negative real (inflation adjusted) return over a 30 year period.  This can be caused by four things---inflation, deflation, confiscation, and devastation.   According to the article the only area that an investor should have constant protection against is inflation, the other risks are too low in probability and/or have a high cost of insuring against them.  This is a better idea than the permanent portfolio concept of having fixed allocations to things like gold, silver, treasuries, real estate, stocks, etc.  but it is still flawed.  Bernstein argues that to protect against inflation investors should own global equities, commodity producing stocks, gold, and tips.  These assets may protect against inflation but they can also do poorly in other environments, like gold did in 2013.  

We know that markets will go up and down, interest rates will go up and down, inflation will do up and down, commodity prices will go up and down, etc.  We just don't know when.  Having fixed allocations to protect against any of these risks is like using a sledgehammer to kill a bug--it may work but it is overkill and can cause collateral damage.  None of these markets events happens overnight.  If you keep in harmony with market trends you will automatically adjust your portfolio to be responsive to anything that could and will happen.

Friday, December 20, 2013

Gold Set For First Annual Loss in 13 Years

Just read an article in the WSJ this morning about how Gold is down 29% YTD and is set for its first annual loss in 13 years.

Can't help but remember all the people who told me how Gold was a sure thing or how Gold never went down.  The lesson here is pretty simple---don't get caught up in all the fundamental reasons why something should go up or down and don't get caught up in the sales sizzle of people who have a vested interest in trying to get you to buy something.  All of that stuff is rarely right, the market is always right.  Follow the trends and counter trends and you will be ok.  There will be a time when it makes sense to buy Gold again but don't try to pick the bottom, you may get lucky here and there but that is rarely a winning strategy.

Tuesday, December 17, 2013

Outlook for 2014

As we get closer to the new year, my inbox is starting to get flooded with different market outlooks for 2014.  Because of this I thought I would chime in with my own outlook:

1. Most of the outlooks that come out will be completely wrong so I will delete all of them immediately except for the ones that come with funny comics.

2. One or two will be right, not because the authors have any special insight, but for the same reason a broken clock is right twice a day.   With enough people making predictions, statistically speaking, one or two will guess right.

3. The one or two who guessed right will be paraded in front of the financial media as great experts.  The media will also probably ignore the fact that they probably guessed wrong every other year.

4. The US market will probably fall somewhere between up 35% and down 35%

5. It will be no easier to predict what the market will do (impossible) in 2014 than it is any other year.

6. Bonds will either be up or down

7. Markets will continue to move in recognizable trends and counter trends

8. Instead of trying to predict what the market is going to do investors will be better of investing with these trends and counter trends.