Sunday, July 27, 2014

Investors and Financial Professionals Think About Risk Differently

A colleague just forwarded me an article about how Investors and Financial Professionals both think about risk differently:

This is something we see every day and it manifests itself in  two main areas:

1. Financial professionals think of risk in terms of standard deviation while investors think of risk in terms of drawdown and loss.  

So when financial professionals look to reduce the risk of portfolios they look for non correlated asset classes to reduce portfolio volatility.  This creates a portfolio that appears to diversified but often does nothing to reduce drawdowns or losses as having asset classes like commodities and different stock sectors offers little, if any, protection during a crisis.

Investors always remember their high water mark.  No matter how much money they have made, if they are under their high water mark they will not be happy.    Portfolios should be designed that keep drawdowns to absolute minimums.

2. Financial professionals assume that risk tolerances are static but investor risk tolerances seem to change based on the current market.

So when financial professionals attempt to deduce a client's tolerance for risk, little if any emphasis is placed on the current environment.  In real life though, when you ask an investor how comfortable he is with loss in March of 2009 when the market has just gone down 60% you are very likely to get a different answer than if you asked that same client today.  

In reality, most investors want absolute returns in a down market and relative returns in an up market. Any approach to minimizing drawdowns needs to take this into account.  For example, you could potentially minimize drawdowns in a stock portfolio by adding bonds.  This can reduce drawdowns in a crisis but it usually also reduces the upside in a bull market.

Thursday, July 24, 2014

Why I don't Stop Buying Small & MidCap Stocks: The Anatomy of a Trend Following Trade Plan

This year we have had some issues with small and mid cap stocks.  It seems like every time we buy them they end up under performing large cap stocks.  The problem has been that small and mid caps have been extremely choppy this year.  They will have a period of out performance causing us to get in and then a period of under performance causing us to get out.

This has happened a couple of times this year and someone recently asked me why we don't start ignoring the buy signals for small and mid caps.  The reason we don't goes into the anatomy of how a trend following trade plan actually works.  In any trend following trade plan you are going to have a certain amount of trades.  A percentage of these trades will be profitable and a percentage will be losers.  As long as your expected return per trade (average return over all trades) is positive it doesn't really matter what your percent of winners vs. losers is.   Also, if you look at a distribution of all trades you will typically see most of the profits come from a very small amount of trades, with the rest tending to be small gains or small losses.  So in a well designed trend following trade plan you know that the monster trades are out there and you know that your expected return per trade over time is profitable, you don't know the outcome of any one trade.  It could be a loser or it could be a monster profit.

Where trend traders often fail is they have a string of the loser trades and instead of focusing on the long term, they decide to pick and choose the signals they will take, often resulting in the missing of a monster trade.  The story of the Turtles illustrates this well.  Two successful futures traders made a bet about whether ordinary people could be taught to be traders.  They hired people from all walks of life and gave them a very successful trend following trading system that relied on a few monster trades for the bulk of profits.  All they had to do is take the signals and over time they would do very well.  With all of that, some of the hires failed.  They had a string of losers and starting picking and choosing what trades to take, causing them to miss the monster trades that would have made up the bulk of profits and turning profitable systems into losers.

The moral of the story is that if you have a well thought out trend following methodology, where you are constantly evaluating it and looking to improve it and where your expected return is positive, then you cannot pick and choose what signals you are going to take.

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.