Saturday, April 21, 2012

When Investing Trends Won't Die

When Investing Trends Won't Die

Story in the WSJ this morning about how investors could get burned betting on things getting back to normal.  The trades mentioned were the VIX, an increase in interest rates, and natural gas, but the list could go on and on.  Trying to invest against the trend can make you a tremendous amount of money if you hit it right but that happens infrequently and is usually a result of luck, not skill.  It is tempting to try to get into something on the low and we have all heard that the way to make money is to buy low and sell high.  However, this is much easier said than done.  Any gains you can make from lucky trades are often swamped by the losses from the times when the trend persisted.  So unless you have a crystal ball a better approach, one that does not rely on luck, is to stay in harmony with market trends----buy high and sell higher.

Saturday, April 14, 2012

Long/Short Funds

Good article in the WSJ about Long/Short mutual funds that attempt to reduce risk by allowing short exposure. 

Stock Funds For the Timid

While I like the idea of these types of funds, investors need to do their homework as with anything there will be some great, good, bad, and awful ones.  The article talks a lot about higher fees which to me isn't a big deal as long as you get what you pay for.  Most traditional mutual funds are closet indexers so paying them 1% or more has never made any sense to me, you can just buy the index instead for much less.  However, if a fund can avoid some or all of the big losses in the market than it is worth paying much more for. 

The bigger issue is that the best long/short stock pickers will almost always gravitate towards the hedge fund space because that is where the money is.  You need extra skill here as shorting is much more difficult than just mirroring your benchmark.  Of course we still think tactical is the way to go but a good long/short fund or two can definitely do better than traditional style box mutual funds.

Thursday, April 12, 2012

A Tactical Approach to Core & Satellite

Core & Satellite portfolio construction arose out of the failure of Modern Portfolio Theory (MPT) to protect portfolios from downturns.  Many advisers now understand that MPT doesn't work, it just appears to work during an up market (along with everything else).  The obvious solution is a 100% tactical approach but for many going from 100% buy and hold to 100% tactical is too much to ask (even though it is a better way) hence the development of Core & Satellite.  The idea is to mantain a 60-80% buy and hold core that would be in an index fund that tracks something like the S&P 500 or the Russell 3000.  You could also include an international index fund and bonds.  The remainder of the portfolio would be the satellite which would include defensive and opportunistic investments. 

While this beats MPT, you are still subject to massive losses in a down market.  A major improvement on this idea would be a 100% tactical Core & Satellite Portfolio.  To see how this works we did the following:

1. Created a core that puts 40% in a tactical strategy that rotates between the S&P 500 (SPY) and bonds, 10% in a strategy that rotates between the MSCI EAFE (EFA) and bonds, and 10% in a strategy that rotates between Emerging Markets (EEM) and bonds.
2. Created 4 satellites and put 10% in each.  Satellite one rotates among a basket of 2x levered index funds or ETFs, Satellite two rotates among a number of different asset classes, Satellite three rotates among a number of defensive assets----Gold, Swiss Franc, etc, and Satellite four is a VIX hedge.

We ran the numbers using TradersStudio software from 4/19/05 to 4/11/2012.  We did not include commissions as I can buy and sell most of these without them.  We also did not includes fees or taxes.  The results are as follows:

Average Annual Return: 16.04%
Maximum Drawdown: -8.79%
Best Month: 10.35%
Worst Month: -3.90%
Sharpe Ratio: 1.3065
MAR: 1.8249
2008 Return: 14.80%