Friday, February 29, 2008

Channeling my inner contrarian

If the adage of value investing is “buy 'em when there is blood in the streets”, then value investing is inherently difficult. It means doing things will make you truly queasy. What’s more, classic value investors tend to be early and will suffer early losses before their investments turn profits.

With those thoughts in mind, let’s look at what broad themes there are that would make the stomach turn:

Junk or just non-AAA fixed income paper for the patient money: In some of these markets there are no bids, which would make it ideal for an investor with a long time horizon and the ability to analyze bond covenants. This story explains some of the structural problems with this kind of paper and the opportunities associated with them. Key quote:

But it looks like now could be the time for big and patient investors (such as Warren Buffett) to start snapping up relatively good-quality credit.

Bottom-up systematic, or equity quant investing is out. There was something comforting about systematic quantitative investing. You had all these tools and could look back at history to see how different techniques performed in past markets. What's more, it was highly risk controlled. Over time, the barriers to entry to using these techniques came down and it became too easy to run these strategies. In August 2007, virtually all quants suffered large losses. They were in a crowded trade and someone ran for the exit (see here). So let’s try something different.

How about top-down macro discretionary investing? People who can spot long-dated investment themes and have the strong temperment to bet on them are worth their weight in gold (warning: their results can be volatile). Find a manager like Ken Heebner, who was prescient about the fall of housing and thought that the housing could collapse by 50% in selected markets. Another is Eric Sprott in Canada, who was early to jump on the commodity bandwagon. I mention them to show examples of portfolio managers who display a top-down, analytical but non-quantitative systematic style of investing (and not to endorse either Heebner or Sprott).

If quant investing is out then maybe good old small-cap fundamental analysis is in. Fundamental analysis can shine in the smaller capitalization part of the market, where having managers and analysts who really understand what drives companies give them a bigger edge. However, I may be very, very early on this theme as the small cap cycle may have turned.

How about buying the US Dollar for a trade to turn your stomach really queasy? The deteriorating fundamentals of the US Dollar are well known and I believe that the currency is in a long-term bear market. However, when stories like this appear the Dollar may be poised for a rally and fool all the bears (and smack all the commodity bulls around too). Be careful - if you time this wrong this trade isn't like catching a falling knife, but falling boulders with knives sticking out of them.

Monday, February 25, 2008

Jacobs & Porter on Development

Back in the days when I had the occasion to interview job candidates often one of my questions was “name the two or three most important people in shaping your life so far, either personally or professionally (and it’s OK to say it’s your mother).” That was, I could get a sense of the person’s interests, passions and more importantly, how he looks at the world.

If asked the same question, I would say a couple of people who have influenced my thinking were Michael Porter and Jane Jacobs. My interest came from my stint as an emerging markets manager during the mid 1990s.

When I used to get assigned a country or region, I used to try to talk to the local investment managers, local brokers and then the companies, in that order of preference. Usually local investors drove the market and it was important to understand their analytical viewpoint. The local brokers also instinctively understand this and will tailor how they cover the local companies and industries accordingly. Until an investor understands how the local companies trade it will be impossible or risky to develop a quantitative framework for those companies.

After going through these exercises a few times, I came back to the same question over and over again.

Why are China and India booming and Kenya not? Typical academic development economic study programs focus on the China and India success stories but don’t focus on the failures. (Incidentally, one of the questions back in my youth was “why can’t India be like Japan?”)

I found the answer first in Michael Porter’s The Competitive Advantage of Nations. In the book Porter talks about how countries go through different stages of development as they migrate up the value chain and also of the importance of industry clusters. Later I also discovered Jane Jacobs’ work, see examples here and here. Her writing is more academic and less punchy but essentially say the same thing as Porter on the issue of moving through stages of development. The important difference is that Jacobs identified city and city-states as the units of growth, rather than nations. While Porter alluded to this point with his industry cluster comment, Jacobs was more explicit.

Could these lessons be generalized to other development economic problems, such as the issue of how to revive inner cities? This is a controversial topic and comments are not only welcome but invited.

Wednesday, February 20, 2008

Examining your assumptions: The Fundamental Law of Active Management

This is one of a series of posts on the importance of understanding the assumptions behind a quantitative model. As I understand it, the Richard Grinold paper on the Fundamental Law of Active Management is now part of the CFA reading:

What Grinold means by the above formula is that a manager’s value-added (Information Ratio) is a function of his selection skill (Information Coefficient) and the number of opportunities (N) he has.

No doubt thousands of CFA candidates have read this, memorized the formula and nodded sagely. They may have even tried to apply it in their working lives. Let's look at some of the underlying assumptions behind this model and understand how a blind application of this work may lead to suboptimal results.

What do you mean by IC? Most quants think they know how to measure IC, at least mathematically. However, the Information Coefficient for any selection process will vary according to time horizon. Is your IC the same for 1 day as for 1 month or 1 year? If you assume a flat IC for any time horizon and not incorporate trading cost assumptions this model will generate portfolio turnover that is uncontrollably high. Grinold in his later works elaborated on this turnover issue (see Grinold and Stuckelman, 1993; also Grinold and Kahn, 1995).

What do you mean by N? N is the number of independent opportunities available. If you are running a 100 stock portfolio does that mean that the number of independent opportunities, or ideas, is 100? What if you were picking stocks based on some fundamental criteria (e.g. low P/E) or macro theme (e.g. rising inflationary expectations). Is N equal to 1, 100 or somewhere in between?

Putting it into English

While I am a math geek as much as the next quant, I like to put the ideas into English when I apply them to the real world. The idea behind the Fundamental Law of Active Management is to size the bets according to the edge you have.

Grinold's work is actually a thematic variation on Kelly’s Criterion. John Kelly was a Bell Labs engineer in the 1950s who posed the following problem. Supposing a gambler overheard underworld types fixing a horse race on the telephone, but there was noise on the line. What should the gambler bet given this knowledge and the level of noise (= probability of correct information) on the line? This discussion could then be generalized to a treatise on information content, signal-to-noise ratio, etc.

Tuesday, February 19, 2008

Still more upside potential in the NatGas vs. Oil trade

Back in early December I posted about the oil and natural gas divergence in price and sentiment. Natural gas initially declined against crude oil after that post but has since risen about 10% on a relative basis.

A update of the Commitment of Traders data from the CFTC shows the relative bull case for natural gas vs. crude oil remains intact. The "fast money" large speculators continue to be have a crowded short in natural gas and giving a contrarian bullish signal. On the other hand, the signal from the COT data for crude oil is still neutral.

Friday, February 15, 2008

A buying opportunity in Emerging Markets?

Emerging market equities have been the leaders in the last bull phase of the equity market. Technically speaking, the accompanying chart of the iShare MSCI Emerging Markets ETF (EEM) relative to the S&P 500 shows they are currently undergoing a high level consolidation but the relative uptrend remains intact.

A check in with the smart money shows that the smart funds have a higher exposure to emerging markets or emerging market-like stocks than the consensus. These are all encouraging signs for emerging market equities. There is no doubt that these stocks tend to more volatile than US equities and are at risk of underperforming should the US go into a deeper or more prolonged slowdown than expected. However, I would give the emerging markets the benefit of the doubt but enter the trade with a fairly tight stop. Should the relative chart of EEM vs. SPX break its relative support line, that would be the signal to get out.

Full disclosure:
I have a long position in EEM.

Saturday, February 9, 2008

Smart money postured for a recession

There are many ways of defining smart money. I had a recent post describing a synthetic market neutral fund using a group of smart funds as a way of generating alpha. Using the technique shown in the sidebar (titled Reverse Engineering a Manager's Macro Exposure) I imputed the macro and sector exposures of these “smart funds" and “consensus funds”, which consists of 22 US large cap blend equity mutual funds from the major fund complexes. I found the following significant differences in their bets:

  • Smart funds are more overweight large caps, which tends to be more defensive
  • Smart funds are more aggressively underweight Financials, indicating that their managers don’t believe that the subprime fallout is over
  • Consensus funds are still overweight the Consumer Cyclicals while smart funds are market weight or underweight

In whole, this analysis points to a picture suggesting that this group of smart fund managers are orienting their portfolio to a recession or economic slowdown, while the larger consensus funds are not yet moved that way yet.

Smart funds are more overweight large capitalization stocks, which are thought to perform better in bear markets and recessions.

Smart funds obviously don't believe that the subprime fallout is over as they are aggressively underweight Financials, which is about 20% of the weight of the market. On the other hand, consensus funds are roughly market weight.

Surprisingly, consensus funds are significantly overweight Consumer Cyclicals, while smart funds are market or underweight.

Tuesday, February 5, 2008

An idiot's equity market neutral fund

Here is a simple way of do-it-yourself way of making an equity market neutral fund without having to pay the big fees:

  1. Buy the top large cap Growth and Value equity funds, as ranked by Morningstar
  2. The funds must be no-load mutual funds, have assets of at least a billion dollars and expense ratios less than 1%
  3. Short the S&P 500 Spyder (SPY) against the portfolio
  4. Re-balance the dollar amounts allocated to the funds monthly and re-balance the fund components annually

For the period from December 1998 to Janaury 2008 the synthetic equity market neutral portfolio showed a very respectable annualized return of 6.4% (after fees) and a Sharpe ratio of 0.9. Comparing to the HFRX Equity Market Neutral Index using that index's inception date of March 2002, this portfolio returned 4.5% vs. the HFRX return of 0.6%.

I have been running this simple portfolio out of sample for since December 2003 and the results are similar to the in-sample results. In 2007, the synthetic market neutral portfolio also beat HFRX with 6.8% to 3.4%.

Sometimes the simple solutions are the best.