Smart funds still underweight financials

A reader recently wrote and asked if the smart funds had reacted to the Fed’s rescue efforts of Bear Stearns et al. A check in with the analysis of Smart Funds show that they remain more underweight Financials than they ever have in the last four years, though they have somewhat moderated their underweight. By contrast, consensus mutual funds have moved to a slight overweight in the sector.

Another shoe to drop?
This posture is suggestive that the Smart funds believe that there are more trouble ahead for banks. Barry Ritholtz at Big Picture recently posted on a RBC Capital Markets research report on 5 reasons why bank stocks have not bottomed. I would also add my comment that in extreme market conditions the brokers tend to trade at about book value. Today, most are trading at 1.6 to 1.7 times book. JPM and C moved to a price/book of 1 in the recent turmoil, but they are financial conglomerates and not pure brokers.

In addition, John Mauldin at Thoughts from the Frontline wrote in his weekly newsletter that:

In an opinion letter posted on the SEC website last weekend clarifying how banks are supposed to mark their assets to market prices is this little gem (emphasis [his]):

"Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability."

…There are two problems with this rule. First, it clearly creates a lack of ransparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company. Second, can a forced liquidation or distress sale be from a margin call? Obviousy [sic] the answer is yes. but as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then they find out that the investment bank is valuing them differently on their books than the price at which they were forced to sell, there will be some very upset managers and investors. Cue the lawyers.

In other words, this is going to be a mess.

Have we quants been brainwashed by Barra (II)?

Further to my first post have we quants been brainwashed by Barra, I received a response from Jen Bender of MSCI/Barra who indicated that “it's not use of the same risk models that causes increased correlation in times of meltdown/liquidity crunch.”

I did not wish to imply that it was the common use of the Barra or any other risk model that got equity quants into trouble in August 2007. What got quants into trouble in August 2007 was the mindset of the only active risk that should be taken is stock selection, or residual risk, and that we should control for industry risk and common factor risk such as size, style, etc.

Dan diBartolomeo of Northfield wrote (italics are mine):

…it is common practice to measure risk using the assumptions of uncorrelated residuals, while using stock selection strategies that can only work if equation (1) does not hold (no factor bets). Since active mangers will be concentrating their portfolios in those securities expected to act alike in providing superior returns, the average residual covariance will be positive…Hence, if we use a risk model which assumes uncorrelated residuals we will have a downward biased estimate of the risks not identified by the factors of our risk model.

He went on to say:

One should also be particularly careful with multi-factor selection strategies where some but not all of the selection factors are in common with the risk model. In such cases, the risk model will tend to neutralize exposure to the risk factors, which will lead to the selection of a security set which are weak on the selection factors which are in common with the risk model, while having extremely high exposure to the selection factors which are presumed independent of the risk model. As such, it is easy for a multi-factor selection strategy to become dependent on a single component, defeating the purpose of the multifactor construct.

(I am grateful to George Wolfe for pointing this out to me.)

If the “stock selection alpha is the only acceptable source of alpha” mindset is becoming a crowded trade, then it’s time to move outside of that box. Goldman Sachs published a research report entitled “A Stockpicker’s Reality: Part III, Sector strategies for maximizing returns to stockpicking” in 2002 where they “examine the degree to which risk management strategies can be used to increase returns. This question differs substantially from the normal application of risk control, which is focused on tracking error rather than returns.” Their conclusion was:

- Value-driven methods are most compatible with quantitative risk management of benchmark-driven portfolios.
- Growth-driven methods are far less compatible with strict quantitative risk limits and are more effective in relatively more concentrated, less risk-controlled portfolio construction applications where risk management is handled at the asset allocation level by diversifying across managers.

In other words, different strokes for different folks. (If you would like a copy of that Goldman Sachs research report please email me. )

Sheep can make money too!

As a counterpoint to my post Channeling my inner contrarian I thought that I would write about being a sheep and the advantages of following the crowd.

A few years ago, I managed equity market neutral portfolios at a firm that was mainly known for commodity trading using trend following techniques, which are well described by Michael Covel in his book. During my tenure there I noticed that while the commodity positions were spread out among various futures contracts they often amounted to a few macro bets (i.e. on interest rates, on the US$, etc.) I came to the conclusion that these models were identifying macroeconomic trends that are persistent and exhibit serial correlation, which creates investment opportunities for patient long-term investors. For example, if the Fed is raising rates the odds are they will continue to raise rates until they signal a neutral or easing bias, i.e. there is a trend to interest rates, which is information that investors can use. The key risk in this class of models is knowing when to exit the trend, as short and long term reversals can be devastating to the bottom line.

With those principles in mind, here are some of the big macro trends that could be investment opportunities (and this shouldn’t be a surprise to most people):

• The falling US Dollar
• Worldwide inflation, especially in commodity prices
• Growth in China

The falling US Dollar

The accompanying chart shows the US Dollar Index in a multi-year downtrend (this is where technical analysis is useful as it spots long term trends). The currency is reflective of investor concerns of the current account and fiscal deficits going out as far as the eye can see and no meaningful policies to reverse them. The recent Fed actions of rescuing the system from collapse have led to some to question the Central Bank’s inflation fighting credentials, which have resulted in additional Dollar weakness. In the short term, however, the US Dollar is near the bottom of its channel and seems to be poised for a counter-trend rally.


Worldwide inflation, especially commodity inflation
Inflation is everywhere and spreading. You just have to read stories like Stop the inflation in the US and Workers strike at Nike contract factory and demanding 20% raises in Vietnam, a low-wage country that had previously been a source of deflation.

Commodity inflation is not just restricted to headline commodities like gold and oil, but is very broad based can be seen in foodstuffs (which begs the question of whether Core CPI = CPI ex-food and energy is a good indicator of inflation). The accompanying chart shows the Continuous Commodity Index (CCI), which is a continuation of the old equal-weighted CRB Index before its re-constitution to a liquidity-weighted index in 2005. The CCI has been advancing in the major non-US currencies as well as US Dollars, indicating that the commodity advance is 1) broad based and 2) independent of US Dollar weakness.





Similarly, gold prices have also been showing a similar pattern to the other commodities. Gold appears to be regaining its former status as the alternative reserve currency. As I indicated before, the US Dollar is likely to rally in the short run and gold and other commodities would run into a headwind under such a scenario.




"Peak Oil" is an additional possible bullish dynamic for oil prices
Crude oil has a possible bullish dynamic of its own in addition to the rising trend in commodity prices: Peak Oil. Much has been written about peak oil by the likes of Matt Simmons, various contributors at the Oil Drum and by many others at APSO so I won't repeat them here. If the peak oil theory is correct and world oil production is indeed rolling over, then we are in for a period of very tough adjustments in not only energy usage but in the pattern of economic growth.

Growth in China
The China growth story is well known and likely to persist. However, direct investment in China is problematical because of an ill-formed culture of corporate governance. A recent article in the FT indicates that:

Board structures at Chinese companies can lead to “confusion, ambiguity and potentially ... undermine the board of directors”, according to a study [by Risk Metrics] of the corporate governance risks faced by investors in China.

Even Hong Kong has its problems:

Risk Metrics noted minority shareholders in the two jurisdictions [Mainland China and Hong Kong] do face some common risks. The state’s firm grip over China’s largest industrial and financial companies is mirrored in Hong Kong by the influence of tycoons and their families.

Instead of investing directly into China, I would suggest vehicles such as the Korean market (EWY: iShares MSCI South Korea) as a way of participating in Chinese growth. Countries such as Japan and Korea supply China with capital goods to facilitate growth in the Chinese economy. The accompanying chart shows the relative returns of the South Korean KOPSI Index in US Dollars relative to the S&P 500. The Korean market bottomed out relative to the S&P 500 in 1997 and has been in a relative uptrend since. A trend following investor would look at that chart and say “stay with the trend!”



The key risk to this trade is that the South Korean market is generally thought as as being highly sensitive to world growth and a significant slowdown in the US could affect it disproportionately.

A secular warning for the airlines

I don’t normally comment on fundamental analysis here, despite having been a small cap analyst early in my career. However, since Mrs. Humble Student of the Markets is a pilot and has numerous contacts in the aviation industry I thought I would make an exception.

There seems to be a dearth of flight instructors in North America, largely because of the low paying nature of the job. Recently, Mrs. Humble Student of the Markets was involved in a feasibility study to bring students from China to Canada to be trained as pilots. To make a long story short, she found that there was little spare educational capacity at Canadian flight schools, largely because of an instructor shortage. The parallel situation exists in the US (and in any case the US is not suitable for foreign student flight training in the post-9/11 era.)

Why does that matter? It matters because pilots, and airline pilots in particular, need to be trained as older ones retire. This shortage of flight instructors will eventually feed into a shortage of pilots, which will shift the bargaining power of pilot unions vs. the airlines. In fact, the shortage is starting to be felt in the emerging markets, where there is not a ready supply of experienced pilots. In one instance, an airline based in an emerging market country offered a job to a recently a qualified pilot (commercial multi-engine IFR rating) as a First Officer (co-pilot) with the understanding that he would be promoted to Captain (pilot) after 500 hours of flight time. This would be the equivalent of allowing a fresh intern, one or two years out of medical school, to perform brain surgery.

Back in North America, it probably doesn’t make a huge difference in the medium term as the United States heads into recession, which would likely result in layoffs at the airlines and create a surplus of pilots. Longer term, however, the shortage of flight instructors and eventually pilots is like the plankton disappearing from the ocean – it eventually makes itself felt all the way up the food chain.

How cheap are gold stocks relative to bullion?

My recent post entitled “A short term warning for US Dollar bears and commodity bulls” must have struck a nerve. I received a torrent of responses regarding gold, gold stocks and how the US economy was going down the tank.

In response, I analyzed the question of the relative value of gold stocks compared to gold bullion. The above chart shows the ratio of the PHLX Gold & Silver Index (XAU), which has a longer history than the popular Amex Gold Bugs Index (HUI), to gold bullion. Since the line is near the bottom of its historical range, it suggests that gold stocks are a bargain compared to gold.

A synthetic gold stock tells a different story: Rising production costs
Back in 2006 I wrote a research report (How to Watch for Signs that the Gold Correction is Ending, 15 March 2006; if you are interested in the full details email me and I will send it to you) detailing how to make a synthetic gold stock.

Conceptually a mine can be thought of as a series of call options on the underlying commodity, with the exercise price as the cost of production. If the commodity price falls below the cost of production, the mine operator has the option to either close or mothball the mine until prices improve. I created a synthetic gold stock by building a model based on these principles. Key features of the model are:

• A series of eight deep-in-the-money call options on the price of gold, with terms of 1, 2, 3 … 8 years, which models a mine with an eight year life, a common estimate of long-lived gold mines;
• An exercise price equal to cash production cost of $250, rising each year by the current inflation rate. ($250 appeared to be a common estimate of cash costs for existing gold stocks in 2006);
• Equal amount of gold mined each year; and
• The position is rolled forward once a year at a cost of 1.5%.

Of course, there are some important differences between the synthetic gold stock and the actual gold stocks themselves:

• Gold miners have exploration upside and operational risk, which the synthetic gold stock does not;
• Gold mining companies may hedge the gold price with forward sales and other derivatives;
• Actual gold mines can somewhat manage the cost of production by high-grading when gold prices are low and mining a lower grade of ore when prices are high. The synthetic gold stock’s assumed cost is inflexible.
  

Production costs are rising
The synthetic tracked the actual index reasonably well until 2006 (which was, of course, the out of sample period) when the synthetic began vastly outperforming the actual index. Delving further into the model, I found that the price divergence was explained by rising production costs of shown by the actual gold miners. Recent analysis by David Galland of Casey Research confirms this trend of rising costs at major producers Barrick and Newmont.

So what’s the answer? Are gold stocks cheap or not?
Gold miners are experiencing higher costs than historical experience, which deflates the case that gold stocks are cheap compared to bullion because their margins are lower. However, higher costs can be explained either by companies mining a lower grade of ore in the current high price environment in order to preserve their reserves and asset value (which is bullish), or costs escalating out of control and squeezing bottom lines (which is bearish).

The truth probably lies somewhere in between the two explanations. Given the recent experience of NovaGold at Galore Creek, I would lean towards the latter as a more likely explanation of higher costs.

Here is a stupid question: rather than agonizing which is the correct explanation for rising production costs, why not just buy the synthetic? That way an investor can customize and control his desired risk profile and exposure to gold.

(Warning for individual investors - don't try this at home. The synthetic is a highly sophisticated instrument that even professionals can get wrong if implemented incorrectly.)

Have we quants been brainedwashed by Barra?

This is a line from Star Trek Next Generation when the Enterprise encounter the Borg and the Borg say something like:

We are the Borg, you will be assimilated – resistance is futile.

As a quant I feel like that sometimes when I encounter Barra and its software. The head of a prop desk once complained to me that everyone is using Barra and they were all getting the same solutions. So when the hedge that the software suggested turned sour, the effect was worse because it seemed that everyone else was rushing for the same exit at the same time.

There are also second order effects. Barra has taught us that the sources of equity risk are industry and common factor (style, size, etc.) and it has affected many quants' analytical frameworks. I was recently at a meeting of quantitative analysts when someone presented some equity analysis. There was general agreement was that the solution wasn’t very well-risk controlled as no self-respecting equity quant would compare two stocks (one in Autos, the other in Media) in the same sector against each other (Consumer Discretionary) as they would normalize for industry effects.

Have we been brainwashed to control risk by industry and common factor (and not much else), after being exposed to the Barra risk framework all this time or is this just another example of a crowded trade?

Comments welcome.

Smart funds still more defensive than the consensus

Was Tuesday's FOMC equity rally for real? Or should we take Wednesday's pullback as the real trend in the stock market?

A check in with the smart funds show that they are still more defensive than the consensus. Smart funds are showing a market beta that is lower than 1, or the market. By contrast the consensus funds' beta is at or slightly above 1.

There are very good technical reasons why this market should rally. It is extremely oversold and due for a bounce. However, smart funds don't seem to be convinced yet that this is THE BOTTOM. By this measure, rallies should be viewed as trading opportunities to sell into strength.

A short term warning for US Dollar bears and commodity bulls

As the cacophony of voices calling for doom for the US Dollar (and conversely a rise in commodity prices) come to a crescendo (example here) and gold tops $1,000/oz. and oil tops $110/bbl, I would like to reiterate my word of short term warning for the Dollar bears and commodity bulls. Signs of a speculative blow-off are everywhere.

Sentiment is getting a little extreme for this trade to continue too much further in the short term. Recently Bob Moriarty of 321gold.com sounded a note of caution (italics are mine):

Nothing goes straight up and nothing goes straight down. As edifying as it is to see silver and gold go up almost every day, now and again all markets take a breather.

I run a gold site and it's considered heresy to suggest commodities correct but they do. Even the lowly dollar goes in the opposite direction on occasions.

Ten days later, he hedged his earlier comment and conceded the bullish case for gold based on an apocalyptic scenario for the US economy and Dollar:

It's a time for caution. We SHOULD have a violent correction in gold and silver and the dollar based on emotion and government intervention but we could see $3,000 gold in a week or the start of a living nightmare brought to you by the Gang of Fools in Washington. No one knows.

To me, that was the first sign of a speculative blow-off in the USD and commodities. The second sign: Both Energy and Gold stocks are at or near the top of their relative uptrend channels against the S&P 500. Can they go higher? Yes. However, the relative downside risk in the near term appears to outweigh the upside rewards.

The third sign of excessive bullishness: The Commitment of Traders chart from CFTC data of large speculators in gold show that they are in a crowded long position, which is contrarian bearish:

My inner trader says that we are in the final stages of a speculative blow-off in commodities and has the potential to correct violently. My inner investor agrees with the consensus view, however, that we are in a long multi-year decline of the US Dollar and multi-year rise for commodities.

Hedge fund bodies floating to the surface

A followup to my posts on hedge fund problems here and here, I see that there are more news headlines such as Hedge funds on the brink as US Federal Reserve cash fails to ease crisis. This market is not likely to make a definitive bottom until some dead bodies (literally or figuratively) start to float to the surface. We are starting to see the bodies.

In the short term, however, there could be trouble. The Yen has strengthened against the US Dollar through the 100 level. As I mentioned before, this could portend a panic selloff.

Wall Street nursery rhymes

It's Friday. For your amusement I reproduce some of the traditional nursery rhymes adopted to a Wall Street theme that we used to recite and sing to our daughter:


The five little piggies
This little piggy put in a market order...
This little piggy put in a limit order...
This little piggy traded derivatives...
This little piggy traded cash [market]...
And this little piggy got caught insider trading and went
wee wee wee wee wee...
...all the way to Club Fed.



Old MacDonald
Old MacDonald had a farm,
Ee-ii-ee-ii-oo,
On this farm he had an investment banker,
Ee-ii-ee-ii-oo,
And a Strong Buy here and a Strong Buy there
Here a Buy there a Buy
Everywhere a Strong Buy!
Old MacDonald had a farm
Ee-ii-ee-ii-oo...


Happy Friday!

An idiot's equity market neutral fund: More on Morningstar rankings

I received a lot of feedback on my original post about a month ago entitled An idiot's equity market neutral fund, where I used Morningstar rankings to pick a series of mutual funds in order to produce an alpha. Much of the criticism centered around the use of Morningstar rankings. Numerous studies have shown that relying on Morningstar rankings alone did not produce positive excess returns and that they formed inefficient portfolios (for examples see here, here, here and here).

The key to success of the synthetic equity market neutral strategy's forecast alpha seems to be the change made in 2002 when Morningstar normalizated fund ranks within style groups. This effect was documented by a new study (Morey & Gottesman 2006). In addition, I picked relatively low cost funds with expense ratios < 1%, which should reduce any "headwind" in the process of alpha production.

Hedge fund implode-o-meter

I discovered a neat site called the Hedge fund implode-o-meter, which lists hedge fund blowups. It also shows funds on an ailing list - check it out.

As US equities continue to perform poorly and hedge funds remain highly correlated with the S&P 500, the Implode-o-meter list is likely to grow.

Yen carry trade at a critical juncture

In the last few days much has been made about the Euro going through 1.50 against the US Dollar. I am more concerned about the systemic risks posed by the recent strength of the Japanese Yen as it may lead to a rush for the exits on the Yen carry trade.

The accompanying chart is an index (31 Dec 2000 = 100) of a equal weighted basket of high yielding currencies (New Zealand Dollar, Mexican Peso, Indonesian Rupiah, Turkish Lira and Hungarian Forint) against the Japanese Yen as an pedal-to-the-metal version of the Yen carry trade. The index hit all-time highs in the July 2007 but have fallen about 14% since then and is reaching a critical technical support.

Hedge funds and currency traders who put on such trades tend to be highly levered and they are not well capitalized enough to withstand large losses. In such instances everyone becomes a technician and chart reader. I am sure that there are many stop loss orders placed just below the support line. Should the Yen strengthen further against these high-yielding currencies and these stops are hit, it would be pandemonium as everyone rushes for the exits, leading to a highly disorderly re-pricing of risk by the markets .

If that happens, this risk-avoidance contagion could very likely spread to other markets. Watch out below!

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.

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.

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.

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.

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.

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.

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.