Wednesday, July 25, 2012

Will My Risk Parity Strategy Outperform?

  • Robert M. Anderson, Stephen W. Bianchi, Lisa R. Goldberg
  • A version of the paper can be found here.
“We gauge the return-generating potential of four investment strategies: value weighted, 60/40 fixed mix, unlevered and levered risk parity. We have three main findings. First, even over periods lasting decades, the start and end dates of a back-test can have a material effect on results; second, transaction costs can reverse ranking, especially when leverage is employed; third, a statistically significant return premium does not guarantee outperformance over reasonable investment horizons.”
Data Sources:
The results presented in this paper are based on CRSP stock and bond data from January of 1926 through December of 2010. The aggregate stock return is the CRSP value weighted market return (including dividends) from the table Monthly Stock – Market Indices (NYSE/AMEX/NASDAQ). The aggregate bond return is the face value outstanding (cross-sectionally) weighted average of the unadjusted return for each bond in the CRSP Monthly Treasury (Master) table. The proxy for the risk-free rate is the USA Government 90-day T-Bills Secondary Market rate, provided by Global Financial Data.
In this article, the authors evaluate four strategies based on two asset classes: US Equity and US Treasury Bonds.
The authors analyze the returns over the following intervals:
  • The entire 85 year sample, 1926-2010
  • The 20-year Pre-1946 sample, 1926-1945
  • Post-war, 1946-1982
  • Bull market, 1983-2000
  • The last 10 years, 2000-2010
Here is an outline of the different strategies:
  • Value Weighted: a fully invested strategy that value weights US Equity and US Treasury Bonds.
  • 60/40: a fully invested strategy with capital allocations of 60% US Equity and 40% US Treasury Bonds.
  • Unlevered Risk Parity: a fully invested strategy that equalizes ex ante asset class volatilities.
  • Levered Risk Parity: a levered strategy that equalizes ex ante volatilities across asset classes.
The conclusions from the analysis are as follows:
  • Results are dependent on the time period analysed–suggesting robustness issues.
  • Over the long period 1926-2010, levered risk parity had the highest cumulative return by a factor of three.
  • In four sub-periods, levered risk parity prevailed during the Pre-1946 Sample and the last 10 years.
  • Despite its relatively low volatility, unlevered risk parity beat the value weighted and 60/40 strategies in the most recent period.
  • During the post-war period from 1946 to 1982, both the 60/40 and value weighted strategies outperformed risk parity.
  • Between 1982 and 2000, levered risk parity, 60/40 and value weighted strategies tied for first place.
Borrowing costs matter
To make the analysis more realistic, the authors replace the 90-Day T-Bill Rate with the 3-Month Euro-Dollar Deposit Rate starting in 1971, and use 90-Day T-Bill Rate plus 60 basis points in the 1926-1970 period. Under these assumptions, the 60/40 strategy had a slightly higher return than levered risk parity over the long horizon.
When applied to subperiods, there are three sets of assumptions about transaction costs:
  • The base case assumes borrowing was at the risk-free rate and turnover-induced trading incurred no penalty.
  • The middle case assumes borrowing was at the 3-Month Euro-Dollar Deposit Rate starting in 1971, and was at the risk-free rate plus sixty basis points before 1971.
  • The final case retains borrowing assumptions from the middle case, and adds turnover induced trading costs of 1% during the period 1926-1955, .5% during the period 1956-1970 and .1% during the period 1971-2010.
Over the entire period, 60/40 is the dominant strategy in terms of after-cost returns. However, levered risk parity outperforms in turbulent periods.
Turnover-induced trading costs
Due to difference in frequency of rebalancing, the trading costs for the levered risk parity are much higher than they are for the unlevered risk parity and 60/40 strategies.
Unlevered risk parity has the highest realized Sharpe ratio, with 60/40 coming second.
In conclusion, 60/40 has a substantial probability of beating levered risk parity over the next 20 years and the next 50 years after accounting for borrowing cost and transaction cost.
Investment Strategy:
  1. For defensive investors, focus on unlevered risk parity to maximize peace of mind and risk-adjusted return.
  2. For aggressive investors, contemplate levered risk parity, but find a way to minimize trading and borrowing costs.
  3. If the aggressive investor can not achieve low cost implementation, flip a coin and choose either 60/40 or levered risk parity.
  4. Hope for the best.
Strategy evaluation is an important part of the investment process. It is essential to consider market frictions, the assumptions underlying extrapolations, and statistical significance. The strategy must be evaluated over periods of different length and in different market environments.

Tuesday, July 24, 2012

Imbalance in S&P 500 Seeding Pessimism: Chart of the Day

Smaller U.S. companies are trailing larger ones badly enough to help explain why stock investors are increasingly pessimistic, according toPierre Lapointe, a global macro strategist at Brockhouse & Cooper Inc.
The CHART OF THE DAY displays a ratio of the Standard & Poor’s 500 Equal-Weighted Index, which doesn’t take into account each company’s market value, to the S&P 500, which does.
The ratio peaked in May 2011 and has fallen 6.2 percent since then. Yesterday’s reading was the lowest since February 2010, which showed the equal-weighted index failed to keep up with a 22 percent gain for the S&P 500.
“Individual investors do not feel as rich” as the S&P 500’s performance would indicate, Lapointe and two colleagues wrote in a July 20 report. This would have given investors a reason for concern last week even though the index climbed to a two-month high, the report said.
Only 22.2 percent of the respondents were bullish in the latest weekly survey by the American Association of Individual Investors. The percentage, reflecting the outlook for the next six months, was the lowest since August 2010.
Consumers “starting to feel the pinch” of a slumping U.S. economy may have even more to do with the prevailing view, the Montreal-based strategist wrote. Growth slowed to a 1.4 percent annual rate last quarter from the 1.9 percent pace three months earlier, according to the average estimate of economists in a Bloomberg survey.

Monday, July 23, 2012

Another All or Nothing Day

MONDAY, JULY 23, 2012 AT 11:41AM

While there is still plenty of time left in the trading day, the S&P 500 is currently on pace for its 20th all or nothing day of the year.  We consider all or nothing days in the market to be days where the net daily A/D reading in the S&P 500 exceeds plus or minus 400.  
After a slow start to the year, the pace of all or nothing days for the equity market has picked up moderately in recent weeks.  At the current pace, the S&P 500 would see 36 all or nothing days in 2012.  At this rate, it would be the fewest amount of all or nothing days since 2007, but the fifth most since 1990.

Monday, July 09, 2012

Seth Klarman: The Oracle of Boston

A hedge-fund manager with a low profile and a big following

HEDGE-FUND bosses rarely double as cult authors. But an out-of-print book by Seth Klarman, the boss of the Baupost Group, sells for as much as $2,499 on Amazon. A scanned version of “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor” has been circulating around trading floors. One hedgie likens Mr Klarman’s book to the movie “Casablanca”: it has become a classic.

Why are Wall Street traders such avid readers of Mr Klarman? Baupost, which manages $25 billion, is the ninth-largest hedge fund in the world. Since 2007 its assets have more than tripled, as other funds have wobbled. Baupost has had only two negative years (in 1998 and 2008) since it launched in 1982, and is among the five most successful funds in terms of lifetime returns (see chart), a particularly striking record given its risk aversion. Long closed to new investors, Baupost counts elite endowments like those of Yale, Harvard and Stanford among its clients.
Soft-spoken and based in Boston, a safe distance from the Wall Street mêlée, Mr Klarman keeps a low profile and rarely speaks at industry shindigs. He is probably the most successful long-term performer in the hedge-fund industry who has managed to stay out of the spotlight.
Mr Klarman is a devotee of “value investing”, a discipline forged by Benjamin Graham (see article) and popularised by Warren Buffett, which involves buying stocks at a discount to their intrinsic value. He will look beyond equities for bargains—a good example is Lehman Brothers, which at the end of last year was Baupost’s largest distressed-debt position. But in every investment he insists on a “margin of safety”, the buffer between what investors pay for the stock and what they think it is worth, so they are protected against unforeseen events or miscalculations.
Mr Klarman first became an acolyte of value investing when he worked at Mutual Shares, a value-investing mutual fund, as an intern and again after he finished Harvard Business School. One of his former Harvard professors then recruited him to run a family office for him and three other families, with an investment pot of $27m (Baupost is an acronym for these families’ surnames). Although the fund is significantly larger today, Mr Klarman still runs Baupost like a family office. He is extremely risk averse; his primary goal is not stellar returns but preservation of capital.
In other ways, too, Baupost is not a typical hedge fund. It uses no leverage, which is partly why Mr Klarman is not famous for one stunningly profitable trade, like George Soros’s bet against sterling or John Paulson’s against the housing bubble. Baupost has few short positions and often holds its positions for years, rather than days or months. Mr Klarman is patient and confident enough to do nothing. He currently has around 30%—and has been known to have as much as 50%—of his portfolio in cash. In 2008 Baupost was one of the few firms that had the scale and the available capital to buy up lots of assets from distressed sellers. “The ability to be one-stop shopping for an urgent seller is very advantageous,” he says.
Given Baupost’s allure, it could easily make a killing on fees. But Mr Klarman eschews the generous “2 and 20” compensation structure typical of most hedge funds, which take 2% of capital as a management fee and 20% of gains. Instead, old investors pay “1 and 20”, and newer ones (he has let them in twice, in the early 2000s and 2008) no more than “1.5% and 20”.
That is not the only way Mr Klarman has positioned Baupost in contrast to other funds. He thinks one of investors’ greatest mistakes is chasing short-term performance and obsessively comparing returns with those of competitors and with benchmarks. In the year to April, Baupost was up by around 2%, trailing the S&P 500 (which was up by 11.9%) and the average hedge fund (4.4%). He is probably the only hedge-fund manager ever to tell investors that he does not want to be their best-performing fund in a given year, as he did in a recent letter. He has deliberately maintained a sticky investor base composed almost entirely of endowments, foundations and families, which understand his investment philosophy and will not redeem after a few negative quarters.
Some have nonetheless expressed concern about Baupost becoming a behemoth. The bigger a hedge fund, the more its investments become restricted to bigger companies and the harder it is to generate profits. Returns could flag. “He’s pretty damn big. That doesn’t excite me,” says the chief investment officer of a large American endowment with money in Baupost. Mr Klarman himself says he remains “convinced that unlimited size is a bad idea.” Two-thirds of the firm’s approximately $17.6 billion in growth over the past five years comes from compounded profits, as opposed to new money coming in. In 2010 Baupost returned 5% of investors’ capital, because he did not think there were enough ways to put it to work.
Hedge funds are notoriously monotheistic and usually suffer if the founder leaves. Mr Klarman, who is 55, has already started working with his team on succession planning. Last year he promoted someone to serve alongside him as manager of the portfolio. Mr Klarman has also hired coaches to work with him and some of his team on devising strategy and maintaining the firm’s culture.
In 2011 Baupost opened a London office, its first outside Boston in its 30-year history, to buy assets as European banks deleverage. That has happened more slowly than expected. Mr Klarman has been critical of governments propping up markets through stimulus and keeping interest rates low, all of which has perverted markets. But this is the type of environment where bargains will eventually surface. “Whatever investment success we achieve will take place against a troubled backdrop,” he wrote in January. Last year “felt like we were playing a great hand of cards in the basement of a condemned building filled with explosives during an earthquake.” He did not get where he is now by being an optimist.

Gold Can't Catch a Break

If you think it has been a tough few months for equities, it pales in comparison to the recent performance of gold.  After hitting its high for the year in February, gold has been in a relentless downtrend for the last four months.  In fact, since the February peak alone there have been eight different periods where gold attempted a rally, only to see the advance run out of gas before the commodity could even make a higher high.

Wednesday, July 04, 2012

The Smartest Man is a Firedancer


The Smartest Man is a Firedancer

When the New Democracy party in Greece defeated the anti-bailout Syriza, I was anxious to learn what The Smartest Man in Europe thought of it all.  The next day I flew across the Atlantic to meet him and we had a long discussion about the world financial outlook.  Many of you remember The Smartest Man from earlier essays; I have been writing about him annually for more than a decade.  He has been a friend for thirty years, and during that period he has shown an almost uncanny ability to see major events affecting the financial markets before other observers.  Among these were the fall of Japan as an economic power in the 1980s, the economic changes in China and their significance the early 1990s, and the serious consequences of excessive borrowing in the developed world in the last decade. 
His DNA endowed him with a certain amount of business acumen.  His ancestors operated canteens along the Silk Road, selling food, weather protection and supplies to travelers to India and China.  He apprenticed in finance in New York, but returned to Europe to take advantage of opportunities created during the post-war recovery there.  Along the way he has acquired the ABC’s of European wealth – an airplane, a Bentley and a house on a Cap in the French Riviera.  The depth and breadth of his art collection is impressive, but material things are not what gives him a high.  He gets his thrills from identifying a problem, thinking it through and being right in determining how it gets resolved.  In his ninth decade, he is an inspiration to me.
He started out by saying he had done some preparation for our visit.  “I think the title of your essay should be ‘Dancing around the Fire of Hell.’  For years I’ve been telling you that the accumulation of debt was going to be the ending of the developed world and for years you have been telling me my views are too extreme.  The problem is you are an optimist and I am a realist.  You go around with a smile on your face thinking that there are serious problems facing us, but that everything will turn out favorably because the policy makers will do what they have to do to avoid disaster, and so far you have been right.  The developed economies and their stock markets have plodded along and investors haven’t made or lost much money in spite of the challenges.  At a certain point, however, the temporary measures that the policy makers put in place to avoid financial catastrophe prove insufficient and that’s where we are now.  I’m not saying that it will happen tomorrow but events are falling into place that will take the smile off your face.
“The problem is that most investors think incrementally.  They don’t step back and look at the whole landscape, which includes how we got here and where we might end up.  In democracies the people always want the government to do more for them, but they don’t want to pay higher taxes.  Politicians get elected by promising benefits, not by raising the revenues necessary to avoid increasing debt.  In a developed economy real growth should equal the population increase plus productivity.  For Europe and the United States that’s about 2%, but people there want their economies to grow more than that so the government provides the stimulus to create faster growth and takes on the debt necessary to do it.  Everything is fine as long as the cost of ten-year debt doesn’t exceed the nominal growth rate, but when it does the cost of servicing the debt becomes an unsustainable burden, and that’s where Spain and Italy are.  The United States isn’t quite there yet.
“When governments finally get around to recognizing they are in trouble, what do they do?  They accept the fact that they cannot produce more growth by providing fiscal stimulus because that would only increase the debt problem, and they can’t take the risk of a recession that might clean out the legacy debt obligations because that would prevent future borrowing, so they do the only thing they can do: they print money.  That’s what the Federal Reserve did in 2008 when they increased the Fed balance sheet from $1 trillion, virtually all in the U.S. Treasurys, to $2.5 trillion, with the increase mostly in mortgage-backed securities.  That’s what the European Central Bank (ECB) did in 2011 when the sovereign debt problems of the weaker countries became severe.  The balance sheet of the ECB increased from €2.0 trillion to €3.0 trillion, and the increase was mostly made up of the sovereign debt of the weaker countries.
“This may go on for a while, but it can’t go on forever.  In Europe’s case Germany will stop backing the monetary expansion and the U.S. Fed will get uneasy as well.  As Milton Friedman persistently argued, inflation is always and everywhere a monetary phenomenon.  So far, however, inflation has remained tame because house prices and wages haven’t risen in most places in Europe and the United States (except real estate in London and New York, where foreign capital has flowed in).  At some point, however, inflation will become a factor.
“Right now we’re witnessing a kind of convergence.  The standard of living in the developed world is declining and the standard of living in the developing world is increasing.  Debt to Gross Domestic Product (GDP) ratios in the developed world are about 100%, where, as Ken Rogoff and Carmen Reinhart have pointed out in This Time Is Different, growth becomes modest.  In the developing world debt to GDP is only about 35%, so these countries have a long way to go. 
“When you think about it, there are a lot more people producing things these days than there were thirty years ago.  Up until 1980 the United States was a major manufacturer and accounted for the dominant share of world GDP, about twice as much as it does now.  By 1980 Europe was producing goods for export and Japan was selling cars, cameras and consumer electronics to everyone.  Now China is the second largest economy in the world and is a major manufacturer, having come from nowhere in the 1970s.  With so many places producing so much and some doing it at relatively low cost, is it any wonder that a lot of people in higher labor cost areas like Europe and the United States are out of work?  The U.S. today is primarily a service economy with a trade deficit.  Germany is a manufacturing economy with a trade surplus.  Do you have to ask why one is doing well and the other isn’t?
“Going back to the Greek election, I think it will prove to be a non-event.  Antonis Samaras will agree to adhere to the austerity program the previous government signed in March in exchange for financial relief, but it will be hard for him to deliver as required.  The Greek people won’t tolerate the pain they will be forced to endure.  They are hot-blooded and want to see results quickly.  There are only two ways to solve the problems of the weaker countries:  austerity, which would mean a 10% contraction in GDP (and Greece is already doing worse than that) or default, which is the route that Russia and Argentina took to get back on track.  Ireland is a good example of a country that successfully took the austerity route.
“Before we experience widespread defaults the authorities will pull out every trick in the book to prevent catastrophe.  That’s because there is a general belief that the European Union was a good idea.  In order to compete against the United States and Asia, the European countries had to hang together.  It was as much a geopolitical decision as an economic one.  There needs to be more cooperation among the European leaders.  The first step is to create a coordinated banking system to prevent a run on the banks.  Deposit insurance won’t do the job.  It’s too much to expect the various governments to agree to a political union at this time, but there could be a banking union to prevent the European banking system from collapsing. 
“The next step will be for every central bank in the world to keep printing money.  Ultimately this will bring on a higher level of inflation, but I think the world is ready to accept that.  World leaders will agree that growth should be their objective and inflation will be the price they will have to pay for it.  This may result in some instability among currencies.  Before this happens there will have to be more suffering.  Spain and Greece will default.  There won’t be outright financial disaster because by the time the defaults take place the banks will have sold most of the troubled sovereign debt on their balance sheets to the European Central Bank.  France’s deficit will get worse as Hollande implements some of the programs he talked about in his campaign.  Human beings and governments have an unlimited imagination and they will use it to delay the day of reckoning.  In the longer term the crisis may turn out to be a good thing because the pain of what we are about to go through will prevent it from ever happening again.
“In the short term interest rates should keep rising because debt is increasing faster than GDP.  This should be true in the United States also, but capital is moving there for perceived safety reasons.  After the defaults occur, there will be slow growth.  The defaults will ultimately create a banking crisis, and that will result in a World Economic Conference where the leaders will agree on an objective of 7% nominal growth made up of the 2% real growth and 5% inflation.
“The Federal Reserve has to keep printing money to prevent a recession.  Europe is already in a recession and the ECB will keep printing money, but the Fed may be more aggressive and that could weaken the dollar further.  What we are experiencing is an accumulation of bad decisions.  The worldwide banking system was able to work together effectively to deal with the financial crisis of 2008 but hasn’t done so well since then.  The banks need more capital.  Their loans are being written down.  Their government bond holdings are declining in value.  On top of this, Basel III is imposing additional capital requirements.  How does that make sense?  It’s impossible.  I don’t know whether a default or an economic conference comes first, but in democracies, a crisis usually causes a conference.  In the meantime, capital in Europe will continue to flee to Germany, Finland and the Netherlands.
“So what am I doing with my money?  It is hard to hide in stocks.  Even Danone is reporting disappointing earnings; people are so worried they aren’t even buying yogurt.  The French auto companies are in trouble.  I think gold is going much higher.  I am buying energy stocks because I want to own something real.  Preserving capital is my focus now, not making money, but I like IBM and Apple.  Also some Swiss multi-nationals.  If Obama wins in November the market will go down.  A Romney victory will create a rally, but once he gets into office he will find there is not much he can do to make things better.”
I left The Smartest Man’s office somewhat dazed.  My optimism was clearly diminished by what he had to say, but I still believe that somehow disaster has a way of usually not happening.  It seems clear that world leaders are going to do everything possible to avert a financial catastrophe and I think they have the resources to accomplish that goal.  It does seem, however, that the developed world has to resign itself to a prolonged period of slow growth.

Lunch is for wimps

Lunch is for wimps
It's not a question of enough, pal. It's a zero sum game, somebody wins, somebody loses. Money itself isn't lost or made, it's simply transferred from one perception to another.