It’s not fair! Sequence of returns risk

With the mindset of a long-terminvestor, you avoid a lot of the worries that afflict the frightened hordes.

You’re not scared out by a stock market crash. Nor do you pile in at the top.

Instead you develop the tough-under-fire attitude of a Vietnam veteran on his third tour of duty. When share prices plummet you go surfing, Apocalypse Now-style, while others quiver before CNBC.

“Is that all you’ve got?” you laugh as the stock market falls 10%.

The average after-inflation annual return from shares globally is 5% per year¹. So as long as you sit tight and keep the faith, you’ll eventually be rewarded, right?

Well… yes, probably…²

The sequence of returns matters

You’d better know that there’s another kind of risk you need to think about, and it’s potentially nasty.

It’s this: The return you get in your investing career might be different to the return I get – even if we both enjoy the same average 5% real return over three decades on our investments!

Huh?

I know – it’s counter-intuitive.

It also has a clumsy name. It’s called the sequence of returns risk.

The sequence of returns risk is essentially the risk that fate will deal you a shocking hand – that the timing of bear markets and bull markets will fall less favourably for you than it does for another investor.

It’s why we’re urged to reduce our exposure to the riskiest assets as we approach retirement age.

It’s also why a decade of steep stock market falls could bode well for younger investors who have saved throughout the turmoil.

The best time to get bad hands when you’re regularly putting money into shares is when you’re starting out – because you learn your lessons early, and you’ve got less money to lose.

In contrast, the last thing you would want the day before you retire is to have all your lifetime savings in shares, only for the market to get sliced in half.

How to multiply your money

You might not think it matters what order the market tosses up its treats and its treacherous years.

Returns from investment are multiplicative – you multiply your money!

And every precocious child knows that it doesn’t matter what order you multiply numbers together. You still get the same result.

For example:

1 x 2 x 3 x 4 = 24

4 x 3 x 2 x 1 = 24

3 x 4 x 1 x 2 = 24

It’s exactly the same with investing.

When the market delivers a 20% return, it goes up 1.2 times.

When the market falls 10%, you multiply it by 0.9 times.

1.2 x 0.9 = 1.08

0.9 x 1.2 = 1.08

So why does it matter to us poor strivers exactly when the sturm und drang of a stock market crash hits us?

Well it wouldn’t if you were a member of the landed aristocracy and you were just managing a big pile of loot before passing it onto the next generation (after six or seven decades of compounding and an unsavoury sex scandal or two).

But most of us are investing new money over our lifetimes to ensure our financial futures – and we also have to withdraw our savings in retirement.

And it’s because we add and subtract money from the market over time that the sequence of returns risk can have its wicked way with us.

Here’s one we did earlier

Let’s consider a real world example. Here are the total returns from the FTSE 100 for the five years from 2008 to 2012:

Year	Return
2008	-28.3%
2009	27.3%
2010	12.6%
2011	-2.2%
2012	10.0%

Source: FTSE

Do the sums and you’ll see that’s an average annual return of 3.9% per year.

Now let’s imagine you had invested £100 at the start of 2008. Here’s where your money would have stood at the end of each year:

Year	Return	Investment
2008	-28.3%	£71.70
2009	27.3%	£91.27
2010	12.6%	£102.77
2011	-2.2%	£100.51
2012	10.0%	£110.56

Note: £100 compounded for five years, as per the returns listed.

The first thing to note is that you’ve ended up with less than you might have expected from the 3.9% average annual return.

Plug 3.9% into a compound interest calculator and you’ll see you might have anticipated £121. You got £10 less.

This is because investment returns are geometric, rather than arithmetic. But that’s another article…

Investing in Bizarro World

Getting back to the sequence of returns, let’s imagine you fell through a wormhole and ended up in an alternative reality, and five years in the past.

(Stay with me here!)

Being a good saver, you shrug off your trip through space and time and make your way to the nearest stockbroker. People still need to save and invest for their retirement it turns out, even in this Bizarro World.

But things aren’t entirely the same.

In this alternative reality, the annual returns you get over the five years from 2008 to 2012 are reversed as follows:

Year	Return
2008	10%
2009	-2.2%
2010	12.6%
2011	27.3%
2012	-28.3%

Source: Bizarro World Bank Headquarters broom closet.

This time the big crash comes at the end of the five-year sequence, rather than at the start as it did for us in our reality.

Do the maths and you’ll see you get the same average 3.9% return.

But what about your £100 investment?

Year	Return	Investment
2008	10.0%	£110.00
2009	-2.2%	£107.58
2010	12.6%	£121.14
2011	27.3%	£154.20
2012	-28.3%	£110.56

Note: £100 compounded for five years on Bizarro World.

As we expected, because returns are multiplicative, we end up with exactly the same £110.56 in Bizarro World as we got on Planet Earth – even though the sequence of returns is reversed.

So far so good!

Adding up the cost of bad luck

The complication comes if you are saving or taking money from your investment over the years.

Let’s say you add £20 at the end of each year to your ongoing investment.

In our reality on Planet Earth, this would have played out as follows:

Year	Return	Investment
2008	-28.3%	£91.70
2009	27.3%	£136.73
2010	12.6%	£173.96
2011	-2.2%	£190.14
2012	10.0%	£229.15

Note: £100 initially invested, then £20 added at the end of each year.

What about in the alternate reality, where the sequence of returns was reversed?

Here you’d end up with a different result:

Year	Return	Investment
2008	10.0%	£130.00
2009	-2.2%	£147.14
2010	12.6%	£185.68
2011	27.3%	£256.37
2012	-28.3%	£203.82

Note: Again, £100 in, then £20 added each year. Alternative return sequence.

As you can see, falling through the trouser leg of time³ has reduced your final sum by around 10%.

Now I don’t know how much things cost in Bizarro World, but I’m sure you’d rather have that extra spending money.

More seriously, this is exactly what happens in real life to different investors with slightly different saving schedules. The sequence of returns varies over time, and so two regular savers with the same general strategy but investing over different periods will see different sums accumulated by the end, even if they enjoy the same average annual return.

People who retired in the late 1990s as the stock market soared were laughing.

People who retired in 2003 after several steep market declines?

Not so much.

The science bit: As well as the multiplication, we now have addition in our sums. So the order now matters.

Withdrawal symptoms

More scarily, the same thing happens when you’re withdrawing money.

I say “more scarily” because there’s not much you can do about your savings once you’ve stopped earning.

At least if you’re dealt a rubbish hand while you’re still accumulating money, you can try to find more cash to invest before you retire. You might even enjoy a market rebound on the extra cash you put in.

Once you’re retired though, you’ve no choice but to spend less and cancel your subscription to Caravan Monthly.

Imagine you had £100,000 in 2008. For the sake of this example let’s say you kept it all in the stock market, and you withdrew £4,000 a year.

In the table that follows the third column shows how £100,000 would fare if you kept all your money invested. The fourth column shows the impact of withdrawing £4,000 at the end of each year:

Year	Return	Hands off	With withdrawal
2008	-28.3%	£71,700	£67,700
2009	27.3%	£91,274	£82,182
2010	12.6%	£102,775	£88,537
2011	-2.2%	£100,514	£82,589
2012	10.0%	£110,564	£86,848

Note: £100,000 in with no withdrawals, versus £4,000 taken out each year.

It’s no great surprise to see that taking £4,000 out a year reduces how much money you’re left with at the end.

But let’s now shift our telescope to Bizarro World, to see how its alternative sequence of returns plays out with the same £4,000 withdrawal rate:

Year	Return	Hands off	With withdrawal
2008	10.0%	£110,000	£106,000
2009	-2.2%	£107,580	£99,668
2010	12.6%	£121,135	£108,226
2011	27.3%	£154,205	£133,771
2012	-28.3%	£110,564	£91,914

Note: Alternate sequence for retirement assets on Bizarro World.

As we saw a few months ago when I began this article with the £100 example, with no withdrawals, the ‘hands off’ pot of £100,000 compounds to the same £110,564 in both sequences of returns.

However in Bizarro World with £4,000 per year withdrawals, the sequence of returns turns out to be more favourable for the retiree. She has £5,000 or so extra in her pot in 2012 than the same investor on Planet Earth.

Interestingly, this is the opposite of what we saw with regular savers on Bizarro World earlier on in this article. They did did worse over the five-year period than we did.

But let’s not get too hung up on these specific numbers.

The point is that the sequence of returns can make a difference to how your retirement plays out. Neither you nor I know exactly what those returns will be.

Don’t risk doing badly

Can you do anything to sidestep the sequence of returns risk?

Not a lot. Its impact is mainly down to luck.

You might try to guess if various markets are cheap and to shift your investments accordingly, but many – probably most – people will do worse using such active strategies than if they had just saved and rebalanced automatically.

I think the main response to sequence of returns risk should be:

• To de-risk your portfolio by rebalancing towards safer assets as you approach retirement

• To consider locking in some income – perhaps enough to meet your basic spending needs – when you do retire, perhaps through an annuity.

All investing involves risk. By diversifying your portfolio and playing a bit safer, you can try to reduce the role of luck, and to increase the odds of your plan working out.

How Low Do We Go Before EM Buyers Bite?

LONDON (IFR)—Is the emerging markets sell-off overdone? Just as investors got too enthusiastic about EM debt in the fourth quarter of last year and first of this, pushing yields and spreads ever tighter, the pessimism now hanging over the asset class is equally too extreme, say some bankers.There's no big default on the horizon, despite deteriorating fundamentals in some countries, no balance of payments crisis that's requiring the urgent attention of an IMF worried about regional contagion, and investors continue to sit on plenty of cash waiting for the right moment to step back in. "Yes, there's shock and panic, but one ought to keep a cool head," said Nick Darrant, head of CEEMEA syndicate at BNP Paribas. "The market is very dynamic. In two weeks time we don't know where it will be. These aren't door numbers, markets move around." Every emerging markets index is down for the year with the EMBI Global, which tracks hard currency sovereign debt, leading the way. The index has lost 5.30 percent in the year up to June 11, as worries about when the U.S. Federal Reserve will begin to slow down its asset purchase program have intensified, triggering an aggressive jump in Treasury rates. That, in turn, has led to a fierce sell-off in risk assets, especially emerging markets. Since May 22, the spread on the EMBI Global has widened 70 basis points, which on top of a 65-bp spike in 10-year Treasury yields, means the all-in yield has risen 1.35 percent in a little over three weeks — a very sharp move. The panic has spread to other emerging markets asset classes too, with JP Morgan's GBI-EM index, which tracks local currency government bonds, down 7.5 percent in May. Countries with domestic political problems and big current account deficits, such as Turkey and South Africa, have particularly struggled, as have liquid markets dependent on foreign inflows, such as Mexico. Even JP Morgan's CEMBI Broad index, which tracks corporates including high-yield, and which should, therefore, be less correlated to Treasury yield movements, is in negative territory for the year. It is down 2.68 percent, in line with the performance of the 10-year U.S. Treasury, according to Thomson Reuters. "This sell-off has been long in coming. I think most investors knew that emerging markets had been propelled along by QE in developed markets to levels at which prices did not reflect the fundamentals of the emerging market country concerned," said Timothy Ash, head of emerging markets research ex-Africa at Standard Bank. Investors, however, say the price falls need to be put into historical context, pointing out that the experiences of 2008 and the second half of 2011 were much worse. Many, in fact, say the correction is a necessary process after the markets got too frothy. "The moves are significant but a healthy reminder that prices can go up and down," said Stephen Yeats, senior investment manager at State Street Global Advisors. "What we are seeing is a re-pricing of certain risks." It's the abruptness of the gyrations rather than the general upward direction in itself that is causing some investors to panic. While the market has been expecting rates to rise since January, it's the spike in the 10-year yield from 1.65 percent in early May to a high of 2.37 percent earlier this week that lies behind the big price falls. "Instead of a gradual rates rise and people getting accustomed to that and pricing it in, we've seen a sudden spike with bonds dropping 10 points. It takes a long time to recover from that," said William Weaver, managing director and head of CEEMEA debt capital markets at Citigroup. Low Yield Risk With yields having ground tighter for emerging markets credits over the past few years, a 10-point price drop means big mark-to-market losses for investors. In 2000, for example, Turkey issued a 30-year bond at 11.875 percent. Even if the bond's cash price fell 10 points, investors were getting sufficiently compensated by the coupon. But Turkey's most recent benchmark deal was a 10-year note that came with a 3.25 percent coupon. The bond, which priced at 98.093, is trading at 92.245 on the bid side, according to Thomson Reuters. Investors will no longer be able to post positive returns by just clipping the coupon, and will be nursing painful net losses. Potentially compounding the problem is that most emerging markets investors rarely hedge their rates exposure as the strategy brings its own risks. If the Treasury market suddenly turned around and everyone piles in again, then investors would be long risk and short Treasuries and lose both ways. Value Bets With Qatar '30s above 4.5 percent, Philippines '21s at 3 percent and Brazil '24s around 4 percent, one trader reckons certain assets are starting to appeal. Investors started to dip their toes back in on Wednesday [June 12] after a brutal Tuesday [June 11] with high-beta credits in particular, such as Ukraine, benefiting. And despite the EMBI Global being on course to record only its third negative year since 1995 — the only other two years are 1998, after the Asian and Russia crises, and 2008, following the onset of the global financial crisis — analysts are confident the asset class's performance can turn around in the second half. Joyce Chang, global head of the emerging markets research group at JP Morgan, still expects the index to achieve a positive return by the end of the year, albeit of just 1.1 percent, which would still be a dismal performance compared with last year's 18.5 percent. Ms. Chang recognizes that fixed income has "clearly hit an inflection point," but argues that "it is still possible to generate returns in excess of 5 percent in EM fixed income from current valuation levels for the remainder of the year, and we are prepared to be tactical in our recommendations once we feel that the market technicals have settled." As a consequence of the sell-off, outflows from emerging markets funds have accelerated. The week ending June 5 saw $1.52 billion of redemptions from hard and local currency accounts combined. While that outflow is largely retail-driven, the doomsday scenario is that institutional investors will follow suit, leading to a vicious spiral of tumbling prices, exaggerated by illiquid secondary markets and further redemptions. So far, a disorderly market breakdown has not taken place, and again context is important. Despite the outflows of recent weeks, year-to-date inflows stand at $35.3 billion, according to JP Morgan, which reckons the year will end with $70 billion of inflows. Indeed, cash is king right now. Cash balances have increased by 0.3 percentage points to 3.4 percent over the month, according to JP Morgan's most recent EM client survey. That money will eventually need to be invested. But everything comes back to rates. "Is this THE definitive move in U.S. rates, i.e. is there more upside pressure on U.S. Treasury yields?" asked Mr. Ash. It's the $2.7 trillion question for the EM fixed-income market. By Sudip Roy

The Best Sell Side Report Ever on Value Investing: Why it Works, Risk, Screeners Etc

I apologize for the sensational headline, but it really captures my feelings on this topic. Who says the sell side does nothing? There is a new fantastic report out from Joao Toniato, Ph.D. of Barclays Capitaltitled EQUITY VALUATION ACADEMY: Value for money. The report is a fantastic study on value investing, specifically focusing on the following points;

1. SECTION 1: THE ‘WHY’ AND ‘HOW’ OF VALUE INVESTING  A Three key lessons on value investing B Why does value outperform? C Is value riskier than growth? D Is this the moment for value?

2. SCREENING FOR VALUE A Three key lessons on value screens B How to capture value? C Not for the faint hearted – value needs a longer horizon D It’s a (value) trap! But you can avoid it

3. INVESTMENT CONCLUSIONS A Cash is king screen (non-financials) B Financials Value screen.

Since this report is so fantastic we have replicated it in its entirety (bar legal disclaimers below).  The report is from 22 May 2013. Enjoy! Dont get scared by some of the academic stuff in the beginning.

QUANTITATIVE VALUE INVESTING – “WE ARE EACH OUR OWN WORST ENEMY”

 SECTION 1: THE ‘WHY’ AND ‘HOW’ OF VALUE INVESTING

Three key lessons on value investing : Academic research has investigated the relationship between company valuation and stock market returns in great detail. The debate surrounding value stretches from the findings of Fama & French (1992)2, namely, that the price to book ratio explains a large portion of future stock returns, to recent papers such as Angelini et al. (2012)3, who conclude that the cyclically adjusted P/E is a powerful predictor of future index returns.

In this note we focus on the analysis of ‘value’ versus ‘growth’ stocks. The first group of stocks can be broadly defined as “bargains”, or stocks that trade at a low price relative to their fundamentals (ie, a stock with a low P/E ratio, low P/Book ratio, etc). Value investors often believe that the market has mispriced these companies and a correction will move prices up and generate returns. On the other hand, investing in growth stocks implies paying a premium price (ie, a high P/E, high P/Book, etc) for a stock that offers large growth potential. Investors who follow this route generally believe that the future growth will lead to stock outperformance.

We have examined the academic literature and added our own tests to identify the likelihood and causes of value outperformance and the best approaches to value screening.

We highlight three main lessons from our analysis:

• Value outperforms in the long run. This has been shown in a variety of academic studies4 and our own tests in Section 2 support this conclusion. The main reason is the different rerating of value and growth stocks. For mostvalue stocks the valuation ratios grow after they are identified as value stocks. For the average growth name the opposite is true, as these companies tend to de-rate after they are identified as growth stocks. Value stocks experienced a positive P/E rerating in all but one of the past 13 years. On the other hand, growth names rerated negatively in 12 of the past 13 years. In relative terms the rerating of value stocks was higher than that of growth stocks in all years.
• Value and growth react very differently to earnings news due to the different growth expectations of each class of stock. Value stocks, on average, still show positive returns even after missing earnings forecasts. On the other hand growth names are punished by the market for missing consensus forecasts and only get rewarded when the company beats consensus by a large margin.
• Value is not necessarily riskier than growth. The volatility of value stocks is more often than not lower than that of growth names. In addition, the volatility of negative movements in price is higher in growth stocks in all of the past 13 years.

In addition to the above, we would highlight our view that the current environment is promising for value stocks. With central bank reflation efforts driving investors up the risk curve, easing policy uncertainty and a stretched premium for defensive growth. We believe we could be approaching a tipping point for value stocks.

Quebecor: Valuation Analysis Using Warren Buffett Methodology

Why does value investing outperform?

As far as heated debates in the halls of investing academia go, this is a serious contender for top spot. The general academic consensus is that value outperforms over the long run. However, one question remains: is the outperformance of value driven by a simple risk/reward story? (ie, investors take more risk when investing in value and to compensate for this risk are rewarded with larger average returns). Or are the returns of value and
growth investment strategies a consequence of mispricing? (i.e. the market often overreacts when value names fall out of favour and excessive hype is built around growth names).

Our view is that the latter is more likely the answer. But whether the reader concurs with us does not change the conclusion that value investing has delivered higher returns in the long run.

Re-rating drives the returns of value stocks

Diving deeper into the performance of value stocks, we start by breaking down returns on a single stock into its components:6 Returns can be divided into Dividend Yield and Capital appreciation. And the capital appreciation, by its turn, can be divided into earnings growth and earnings rerating.

We can see that by:

In Figures 5, 6 and 7 we look at each of these components individually. Value stocks, almost by definition, are expected to have higher dividend yields and in Figure 5 we show that the dividend component of returns alone has consistently been higher for value names.

The second component of returns yields more surprising results. Growth names, again almost by definition, are expected to have higher earnings growth. And in general that is what we found: in 11 of the past 13 years growth stocks had higher EPS growth than value names (Figure 6). However, the expectation of growth is the main reason for the premium investors pay for these stocks. And looking at the 12m ahead earnings growth over the past years, the results only partially support that the premium paid for growth was “money well spent”. We can see that the EPS growth advantage that investors received for growth stocks is not as consistent or high in magnitude as the dividend yield advantage value investors received for their investments.

While investing in value stocks implies paying for the dividend yield and investing in growth stocks implies paying for strong future earnings, should not come as a surprise, what is often ignored is the P/E rerating component.

The P/E rerating works as a multiplier which defines how much the earnings growth affects the capital appreciation/depreciation of the investment. So, for example, let us suppose that an investors buys £1000 of a stock and holds it for one year; and when the position is opened the stock has EPS = £10 and trades at a P/E = 10x. Now let us assume this stock doubles its EPS over the year. In this case the invested capital will only double if P/E stays put at 10x. But if the stock’s P/E rerates to 15x the capital will actually treble (i.e. when the position is closed: EPS £20 * P/E 15x = £3000) while, if the P/E de-rates to 5x the capital appreciation will be zero (i.e. when the position is closed: EPS £20 * P/E 5x = £1000).

With that in mind, we looked at the rerating of value and growth stocks over the same 13 year period. In Figure 7 we see that the rerating has magnified the returns of value names in all of these years except for 2008. While the returns on growth stocks were diluted by derating in all but one of the past 13 years.

Hence, while growth stocks benefit from stronger EPS, growth stocks tend to rerate negatively. In other words, as their earnings grow, the value the market attaches to these earnings is constantly falling. It appears that growth companies consume their growth opportunities quickly causing PEs to fall, so limiting the returns on investing in growth names.

The reverse is true of value names, which show (often strong) positive rerating in most years. Hence, even in the face of the weaker earnings growth shown by these stocks, the rerating adds to the higher yield and generally translates into outperformance of value stocks.

This type of analysis was suggested in The Anatomy of Value and Growth Stock Returns (by Fama & French)7. In this paper the authors conclude that value portfolios generate large capital gain returns via rerating. By contrast, growth stocks re-rate negatively causing the P/E ratios of growth and value portfolios to converge over time.

The analysis above begs a follow-up question:

How do value and growth stocks react to earnings news?

Given that value stocks appear to carry the expectation of low earnings growth, what happens to those value stocks where there is upside surprises on earnings? And if the price of growth stocks already implies high earnings expectations, are they still rewarded for reporting high earnings? To answer those questions, we look at the returns of value and growth stocks when they miss/beat analyst expectations.

In Figure 8 we plot the average 12m post earnings announcement returns of value and growth stocks since 2000. We can see that these two types of stocks react in very different ways depending on what was disclosed in the earnings announcement. It appears that the price investors pay for growth stocks on average already carries strong earnings expectations; so much so that unless the company beats consensus by a significant margin, the share price reaction is negative.

We note a few other interesting conclusions from the above chart: firstly, value stocks appear not to be punished by the market for missing analyst forecasts. These stocks seem to already carry the expectation of poor earnings in their valuation. Secondly, for value names even a small beat to consensus is largely rewarded by the market. Even more startling are the conclusions for growth stocks. Firstly, for growth stocks, missing analyst forecasts results in average negative returns. Secondly, the average growth name is not rewarded for a small beat to analyst forecasts, only strong surprises (>10% above forecast) result in positive returns.

Supporting the argument that the different reaction to earnings news drives much of the difference between the returns of value and growth stocks academic research (Good News for Value Stocks: Further Evidence of Market Efficiency – by La Porta, Lakonishok, Shleifer & Vishny8) has found that “the earnings announcement returns are substantially higher for value stocks than for glamour (growth) stocks”. In other words, as it is clear from Figure 8, positive reaction to earnings announcements are consistently more common for value names than for growth names.

This can also be seen by looking at a particular class of stock: value names that report earnings growth. Those value stocks that manage to grow earnings on a given year tend to yield very strong market performance as well. If we look at value stocks that grew earnings in the year after being selected as a value name (Figure 9) the returns are exceptionally strong.

In other words, the “holy grail” of value/growth investing appears to be investing in value names that will grow earnings/beat earnings expectations during that period. The question then becomes: how do we identify those value stocks with potential to surprise on earnings? These are truly the companies where the market has underestimated the potential of the assets in place, i.e. they are currently mispriced. We try to answer this question in Section 2 where we attempt to identify the best ways to screen for value and to avoid value traps.

Howard Marks: The Wisdom of a Value  Investor

Is value riskier than growth?

Now we turn back to the initial question of whether the outperformance of value is driven by risk or mispricing. As we wrote above, our view is that mispricing may play a larger part. First, the results we saw in Figure 8 above point in the direction of the mispricing theory. It appears that market earnings expectations about growth stocks are so high that even when earnings are marginally above analyst forecasts this does not translate into positive returns.

To further explore this we look at the volatility of value and growth stocks. These tests also imply that risk is not the determinant of value returns since in 8 of the past 12 years growth stocks showed higher volatility than value stocks (Figure 10).

The academic research answer to this question is still unclear and there is no consensus in the literature concerning this topic. On one side of the debate, a classic paper, Size and Book to Market Factors in Earnings and Returns (by Fama & French)9, argues that in the same way that value stocks yield higher price returns they also display higher risk. So these authors defend that the greater returns to value stocks are the result of this risk/reward trade-off.

The results from the tests of Fama and French indicate that the beta of the CAPM model alone is not capable of explaining the variation in returns across companies and that valuation and size play an important part in explaining returns. Fama and French frame their arguments along the lines of the Fama and French (FF) 3 factor model which is an expansion of the CAPM model10.

CAPM model: Rs – Rf = ? + ?*(Rm – Rf)

FF 3 Factor model: Rs – Rf = ? + ?*(Rm – Rf) + H*HML + S*SMB

Where: Rs is the return on a portfolio, Rm is the market return, Rf is the return on the risk free rate, HML is the ‘high minus low’ book to price factor (which is measured based on the historic outperformance of low P/B over high P/B stocks) and SML is the ‘small minus large’ size/liquidity factor (which is measured based on the historic outperformance of small cap over large cap stocks). So, while the CAPM argues that beta and the excess return on the market alone are able to explain single stock returns; the FF 3 factor model states that valuation (as captured by the price to book ratio) and stock liquidity/size also impact returns. Fama and French try to categorise the P/B and size factors along the same lines as beta; i.e. as factors that capture risk. However, their research fails to provide a sound economic rationale for why low P/B names would intrinsically carry greater risk.

This led other researchers (as well as Fama and French themselves) to question the risk explanation for the outperformance of value companies. In the paper, Contrarian Investment, Extrapolation, and Risk (by Lakonishok, Shleifer & Vishny) 11 argue that market participants “consistently overestimate future growth rates of growth stocks relative to value stocks” and that “value strategies appear to be no riskier than growth strategies”.

This implies that the returns to value stocks are a consequence of mispricing.

Another important point is that the 4 years when value showed higher volatility were also years in which value stocks significantly outperformed growth stocks. This suggests that the volatility we are looking at even in those 4 years is a “good volatility”, i.e. prices increasing fast rather than falling.

Jeremy Grantham's 10 Investment Lessons:

1. Believe in history: "history repeats and repeats, and forget it at your peril. All bubbles break, all investment frenzies pass away."

2. Neither a lender nor a borrower be: "Unleveraged portfolios cannot be stopped out, leveraged portfolios can. Leverage reduces the investor's critical asset: patience."

3. Don't put all your treasure in one boat: "This is about as obvious as any investment advice could be ... Several different investments, the more the merrier, will give your portfolio resilience, the ability to withstand shocks."

4. Be patient and focus on the long term: Wait for the good cards. If you've waited and waited some more until finally a very cheap market appears, this will be your margin of safety."

5. Recognize your advantages over the professionals: "The individual is far better-positioned to wait patiently for the right pitch while paying no regard to what others are doing, which is almost impossible for professionals."

6. Try to contain natural optimism: "optimism comes with a downside, especially for investors: optimists don't like to hear bad news."

7. But on rare occasions, try hard to be brave: "You can make bigger bets than professionals can when extreme opportunities present themselves because, for them, the biggest risk that comes from temporary setbacks - extreme loss of clients and business - does not exist for you."

8. Resist the crowd, cherish numbers only: "this is the hardest advice to take: the enthusiasm of a crowd is hard to resist. The best way to resist is to do your own simple measurements of value, or find a reliable source (and check their calculations from time to time) ... and try to ignore everything else."

9. In the end it's quite simple, really: "GMO predicts asset class returns in a simple and apparently robust way: we assume profit margins and price earnings ratios will move back to long-term average in 7 years from whatever level they are today. We have done this since 1994 and have completed 40 quarterly forecasts ... Well, we have won all 40."

10. This above all, to thine own self be true: "To be at all effective investing as an individual, it is utterly imperative that you know your limitations as well as your strengths and weaknesses ... you must know your pain and patience thresholds accurately and not play over your head. If you cannot resist temptation, you absolutely must not manage your own money."

Read more: http://www.marketfolly.com/2012/03/jeremy-granthams-10-investment-lessons.html#ixzz2VvlvEj6v

Quant hedge funds hit by US bonds sell-off

©Chris Batson/FT

Some of the world’s biggest quant hedge funds have suffered steep losses in the past two weeks following the sell-off in global bond markets.

So-called “CTAs”, which use computer models to automatically spot and ride market trends, were caught out as investors anticipated an end to the Federal Reserve’s measures to stimulate the US economy, triggering a global rout in fixed income investments.

AHL, the $16.4bn flagship fund of Man Group, the world’s second-largest hedge fund by assets, lost more than 11 per cent of its net asset value in the past two weeks alone as a result of its huge bond holdings, according to an investor.Bond yields have risen sharply from some of their lowest levels in decades in the past fortnight, leaving funds with large holdings badly hit. Many quant funds have been major buyers of bonds over the past few years as their algorithms have followed yields lower.

“Since mid-May it has been a perfect storm of some of the biggest trends in markets reversing all at once,” said a senior manager at one large quant fund. “It has been particularly brutal.”

News of the fund’s difficulties triggered a 15 per cent drop in Man’s share price on Wednesday.

Aspect Capital, another large European CTA, lost 6.4 per cent in May.

Geneva-based BlueTrend, the $14bn quant division of BlueCrest Capital run by Leda Braga, told investors its fund was down 4.4 per cent for the month as of May 24. The fund has yet to reveal losses incurred last week, but investors say they are likely to be high. BlueTrend runs a more volatile version of the same strategy as Man.

Sources at the funds say this week has also been painful and losses have been extended.

Most quant funds only privately communicate performance data with their investors on a weekly – or even monthly – basis.

Many of them have also had long positions on contracts linked to Japanese equities. The Nikkei has slumped 5.5 per cent so far this week, extending a month-long fall.

“May has rattled investors with large bond portfolios,” said Anthony Lawler, portfolio manager for hedge fund investor GAM. “Across all [hedge fund] strategies, trades that caused pain included long fixed income positions and long exposures to the many markets that reversed or were choppy, including energy, Japanese equities and soft commodities.”

Although CTAs are known to be volatile, the losses are still among the highest reported to investors in years – and have been spread broadly.

Graham Capital, the US’s largest CTA, was down 3.9 per cent for the month, while Holland-based Transtrend was down 3.1 per cent.

Winton, the world’s largest quant fund, managed to sidestep the worst of the losses. The London-based company dropped just 2.5 per cent in May, but is still up 6.5 per cent for the year.

Although almost all of Winton’s losses were attributable to US bond market moves, unlike its peers, Winton has moved to diversify its algorithmic trading programmes into cash equities and away from its traditional focus on futures contracts. The fund also operates with lower leverage than many of its rivals.

Mr. Market’s Global Bond Market Allocations

Categorizing the global bond market’s components is tricky. Equities, by contrast, are relatively transparent. For simplicity, I'm streamlining the fixed-income analysis, although no one should confuse the numbers below as the last word on the global bond market mix. For instance, I'm leaving out US munis and collateralized debt.

The source for the investment-grade data is Citigroup, with the high-yield data coming from Markit, and all the numbers reflect market closes at the end of last month. Let’s begin with the big picture for US bonds.

Compared with the February update, US governments’ relative share ticked down a bit while US investment-grade corporates and junk is up slightly:

Comparing the US bond market overall with the rest of the world, the US slice climbed slightly in relative terms since the previous update:

Next, here’s how the foreign markets stack up on an ex-US basis. The main changes since February: foreign developed-market governments and investment-grade corporates hold modestly smaller pieces of the capitalization pie and emerging market governments and foreign high yield have increased their shares a bit:

Here’s how everything compares in relative terms. Overall, not much has changed since the previous update in February, although the relative allocations for US bonds overall ticked up: