Monday, June 29, 2015

I am Getting Sick of this Ongoing Greek Crisis

Back in the old days if you couldn't  pay your bills you went bankrupt.  The people who didn't do their due diligence and loaned you money would have to work it out in the courts.  Today the Fed and the ECB have gone so far down the bailout rabbit hole that nobody is allowed to go bankrupt.  This has probably been one of the reasons that the bull market has gone on so long and been so strong.  When you know that the central banks will bail everybody out then you can take a ton of risk and not have to worry about the downside.  But what happens when everyone takes a ton of risk for a long time?  The eventual crash gets really ugly.  Kind of reminds me of the mortgage crisis in 2008 and the tech bubble of 2000.  The ECB can keep kicking the can down the road on Greece but the road eventually becomes a dead end and you have to deal with the fact that structurally, the Greek economy is different, and at the end of the day they probably just can't pay their bills.   This has been going on now for a number of years and I am getting tired of it.  Letting Greece go under would create some short term volatility but that would eventually subside and we could get on with business as usual.  Investors would also be reminded that their is no such thing as risk free and that they still need to do their homework when decided what to invest in.  Short term there would be some pain, longer term things would be better.  Unfortunately, politicians think about the short term because of elections, and ignore the long term when they are likely to be out of office any way.  

Tuesday, June 2, 2015

A Disaster Waiting to Happen?

If you earn a state pension or live in a state that has a shortfall in their pension then you need to pay attention to pension obligation bonds.

Borrowing to Replenish Depleted Pensions

The idea is that a state issues bonds, borrowing money from bondholders, and invests the bonds in their depleted pensions.  To make the math work the pensions invest the money relatively aggressively and are projecting that they will earn more on the invested money than they will pay out on the bond interest.  If the next six years in the stock market look like the past six years then this will all end well.  If they don't, then it could make a bad problem really bad.  Kind of like what happens when you borrow from one credit card to pay off another credit card---usually things don't work out that well.

Nobody knows what the market is going to do, but we can learn a lot from history and at least judge the odds of this strategy being successful.  Looking at current stock market valuations based on historical standards, whenever US markets have been at this high a valuation the next 10 years have been mediocre at best.  One of the times when people start bringing out the this time is different argument they will be right, states better hope this time really is different.

Wednesday, May 13, 2015

Targeting Portfolio Volatility

Volatility is an important factor in designing portfolios for clients.  First off, volatility tends to be negatively correlated with returns, meaning when volatility of an asset increases returns tend to decrease.  Second, volatility can hamper the "investor experience".  We have talked about the idea of optimizing investor experience in the past.  It basically means that at the end of some horizon the investor has earned as much as reasonably possibly while being able to tolerate the ride.  When volatility is high the ride is bumpy and becomes much less tolerable.

In traditional portfolio construction volatility is assumed to be static, today's volatility is tomorrow's volatility.  So an investor might construct a 60/40 stock/bond portfolio, using the bonds to dampen volatility.  That same investor might be willing to assume more volatility than a 60/40 portfolio would deliver in a stable environment but not willing to assume the level of volatility the same portfolio would have during a volatile environment, so the 60/40 represents a compromise.  This compromise causes the investor to not make as much as they could during a low volatility period and causes the investor to experience more volatility than they are comfortable with during a highly volatile period.  This eventually leads to a poor investor experience.

Targeting portfolio volatility is a much better approach.  For example, in the same 60/40 portfolio the stocks would be more volatile than the bonds.  Assume you want to target an annualized level of volatility, for example 12%.  During times when stocks are not volatile the percentage of stocks would increase vs. bonds.  During times when stocks are volatile their allocation would decrease vs. bonds.  Instead of a static portfolio the investor would have more in stocks during low volatility environments, setting them up for more potential returns, and would have less in stocks during high volatility environments, lessening the bumpiness of the ride and perhaps avoiding major drawdown.

Wednesday, April 15, 2015

The Biggest Mistake Investors and Advisers Make

Study after study of the money managers who have had the best long term performance shows the same thing----while the money managers made a lot of money over time, the average client lost money.  This isn't some sort of Ponzi scheme, it is because investors and advisers tend to buy into money managers or strategies when they are doing well and sell out when they are doing poorly.

Wall Street does a good job of hammering home the point that past performance doesn't predict future results.  Regardless of how bold that statement is on every marketing piece people still believe the most recent investment past will equal the future.  Last year's top money manager or strategy will be next year's top performer.  Last year's bottom performer will be next year's bottom performer.  This ignores two basic facts about how markets work----investment strategies cycle in and out of favor and everything eventually mean reverts.

It is no secret that investment styles and strategies cycle in and out of favor.  In the asset allocation world there are times when value outperforms growth and times when growth outperforms value.  There are times when small stocks outperform large stocks and times when large stocks outperform small stocks.  In the tactical world there are times when momentum strategies do well and times when the don't.  There are markets that are perfect for counter trend strategies and markets that aren't.  The best investment strategies might crush whatever benchmark you use over time, but day to day, week to week, month to month, there will be times it underperforms.  If investors are constantly getting out during the underperforming periods they usually get out of one strategy at the wrong time and into another at the wrong time.

Investments are also mean reverting.  What goes up big eventually goes down to more normal levels. This happens over and over again with asset classes and strategies---Gold, Apple, Biotech, Japan, etc. Investors always like to buy into what is hot.

We see this in our investment strategies, most new client money flow goes into whatever strategy has had the best recent performance.

I get it, it is much easier for someone to reconcile buying into what is hot than it is to buy into what is not.  But if you constantly rotate from what isn't  hot to what is then you are asking for mediocre investment results at best.  Instead of focusing on buying past performance focus on buying into a process that should produce the best results (tolerable volatility and the best possible returns) going forward and stick with it through the inevitable ups and downs.

Sunday, April 5, 2015

Avoiding Momentum Head Fakes

Momentum is an extremely powerful investment strategy.  The basic idea is that objects that are in motion tend to stay in motion---when stocks are strong they tend to stay strong, when bonds are strong they tend to stay strong, etc.

Momentum investing is based on individual investor psychology. When an asset class starts to move from a downtrend to an uptrend generally the "smart money" gets in first.  This is followed by the "not as smart, but still pretty smart money", then the "still pretty smart, but not quite as smart money", and so on and so forth until the inexperienced investor gets in somewhere near the top.  This cycle generally plays out long enough for the momentum investor to get in once the uptrend has started, get out once a downtrend is established, and still make a lot of money on the trade.

Hundreds of research papers have been written proving that momentum works across asset classes and across time frames.  However, just like any investment strategy, momentum can cycle in and out of favor.  The worst type of market for a momentum strategy is a choppy one, which can result in a number of momentum head fakes.  In a choppy market an asset class might move up for one period, causing a momentum investor to enter, and then move down the next period, causing the momentum investor to exit with a loss.  Repeat this cycle over a year or so and it can be a pretty frustrating experience for investors as they always seem to be buying high and selling low.

Every investment strategy has an Achilles heal, for buy and hold it is a bear market, for momentum it is a choppy market like the kind we experienced in 2014.  This presents a particular problem for momentum strategies as investors tend to be more forgiving of losses when the market is down, misery loves company.  However, they tend to be less forgiving of losses when the market is going up.  A negative year for a momentum strategy while the overall market is up can cause investors to jump ship and miss out on the future benefits of momentum.

The answer to this problem comes from diversification.  Not diversification by asset class---large cap stocks, small cap stocks, international stocks, value, growth, etc, but diversification by methodology:

Option 1: A Core/Satellite Approach---In Core/Satellite approach the investor would have a fixed core of a portfolio surrounded by a momentum based overlay.  In a choppy market the momentum overlay would still be subjected to momentum head fakes but the fixed core would remain invested.  In a bear market the investor would be exposed to higher drawdowns but the losses would be shifted to a down market which is psychologically more easy to tolerate than losses in an up market.

Option 2: Multiple Momentum Approaches---Many tactical managers try to optimize the one best momentum methodology.  A smarter approach would be to combine multiple, uncorrelated momentum methodologies together.  The idea would be that when one is being subjected to momentum head fakes the others are not.

Just because momentum strategies struggled in 2014 doesn't invalidate their effectiveness.  Every investment strategy has a market environment that it will struggle in and momentum did exactly what it was supposed to do in 2014.  As practitioners we need to constantly innovate to address these issues as much as we can to ensure the best possible investment experience for clients.


Thursday, April 2, 2015

ETF Trading Basics

Now that our ETF is out we have been getting a lot of questions about how to trade ETFs.  Here are some basic guidelines:

1. Volume has nothing to do with liquidity--The ability to trade an ETF has nothing to do with volume, it is all based on the liquidity of the underlying basket.  

2. Know the fair value of the ETF when you want to trade it---Quote systems only show the last trade, so if the ETF last traded at 10am and you want to place a trade at 3pm the price you see will be old.  A better way to gauge the value of the ETF is either looking at the Indicative Value (you will need some sort of advanced quote screen for this), or the bid/ask spread, which can be found on Yahoo Finance.

3. Try to avoid trading during the first and last 15 minutes of the trading day--During the open in takes market makers a bit to figure out the prices of all the underlying securities in an ETF.  During that time bid/ask spreads are likely to be wider.  At the end of the day you can see a lot of order imbalances that can also impact spreads.

4. Try to avoid market orders---Market orders put you at the mercy of the market, you are better off placing limit orders.  We can help you decide where to place your limits.

5. Call your block desk on trades over 5,000 shares---Larger trades are better facilitated through your custodians block desk.  They will reach out to various market makers and come back to you with the best price.

Thursday, March 26, 2015

How The Bull Market Might End

Yesterday I was on CNBC talking about how bull markets die slowly and how the sell off was not the beginning of the end, yet:

http://video.cnbc.com/gallery/?video=3000364927

What yesterday might have been though is a sneak peak at what the end will look like.  In this Fed induced bubble bad economic news should be good as it means that Fed tightening will probably be pushed out.  When bad economic news is bad, then that is bad, because it means that the market thinks the Fed might be out of bullets.  If the Fed has exhausted their playbook and we are still headed towards a recession then we have a problem.  Over the past few years we have had a bunch of V shaped moves in the market, something knocks us down but we know the Fed has our back so the market rallies back up.  If we know the Fed has our back but we also don't believe they have any options left then one day we have a decline that doesn't rally back.

As I said on CNBC this bull market will die slowly, but all bull markets eventually die.  Investors who are prepared will be fine, those who have come to believe "this time is different" will get hurt like they always do.