Portfolio Analysis

Hedge Fund Fees

2007-05-03T23:52:00.000+02:00

Bloomberg about the Austrian hedge fund Superfund and their fees:

"Superfund A has to produce at least a 6.75 percent annual return before investors see any gain, according to the prospectus filed with the SEC. Superfund B has to gain more than 8.63 percent."
(Bloomberg: Baha's Superfund Pitch Grabs Ranieri, Annoys Rivals (Update1))

Their funds haven't really seen any performance gains in the past four years, and the accumulated 300% performance they are advertising is from late 2000 to early 2003. Since 2003, Superfund funds are moving sideways - for investors. Superfund is still making 6-8% with the investor's money, as you can see above.

Superfund has been using a technical momentum trend following strategy for dozens of markets, highly leveraged. It can easily be replicated (from what I've been told by some of their former employees and business partners), but as thousands of investors are using very similar strategies nowadays, markets have become too efficient to offer reasonable margin. This is a problem with many of the market timing strategies that have been working for decades (e.g. the simple "buy when price > MA200, sell when below") - too many people are using them. So if you're using timing strategies, make sure it's not a well known one. And putting less than a couple of billion dollars to work will help executing it too.

The next time you hear about David Swensen allocating 20% of the Yale University’s Endowment Fund to hedge funds, keep in mind that he's probably not paying 8% annual fee.

Spanish Property Selloff

2007-05-01T21:06:00.000+02:00

Last week we've seen a major selloff in Spanish property stocks, causing a loss of confidence in the future of the 10 year bull run European property stocks have seen. Over the longer term, this decline will not affect the wider European commercial property market - at least this is what fund managers are saying (what else should they say?):

"There is however no reason yet to believe that the effects will be this extreme, and for time being we welcome a necessary correction in an overheated market." (Patrick Sumner, Head of Property Equities, Henderson Global Investors)

If you're searching for an ETF covering the European Real Estate Market, you might want to take a look at the iShares FTSE/EPRA European Property Index Fund (IPRP:LN), registered in Ireland.

Emerging Middle East & Africa

2007-04-26T02:28:00.000+02:00

In case you missed it, the first regional Middle East/Africa ETF was launched just a few weeks ago: SPDR S&P Emerging Middle East & Africa (GAF). One might want to call it 'SPDR S&P South Africa' instead, as it's heavily overweighted in South Africa (66%), with exposure to only a few other countries (16% Israel, 6% Egypt, 6% Morocco).

South Africa might be an interesting country over the next 1-2 years for several reasons: the FIFA World Cup 2010, and a large and active stock exchange that ranks 17th (I've read 15th somewhere else) in the world in terms of total market capitalization - but it's not the country you'd expect to be overweighted in if you're seeking exposure to the middle east. JPMorgan's Emerging Europe, Middle East and Africa Equity Fund basically just adds a lot of exposure to Russia, so this doesn't really help either (besides: noone seems to be interested in mutual funds these days, even if there's a growing number of ETFs with a high TER).

Thomas Lagoarde-Segot (University of Dublin) has published an IIIS disucssion paper covering the MENA (Middle East and North Africa) market last summer - here's an excerpt of the abstract:

"Our results suggest that in spite of intra-regional heterogeneity, the MENA region ranks favorably by comparison to Latin America and Eastern Europe. We can therefore expect greater international financial integration of the MENA region in the near future."

Currently there's no easy way to invest in the MENA market, including countries like Israel, Egypt, Turkey, Kazakhstan, Morocco, Jordan, United Arab Emirates, Qatar, Kuwait, Bahrain, Oman etc. But as soon as oil climbs back to the 70s, I bet someone will launch an ETF. And by 2010 we'll probably have a frontier ETF covering Kenya, Cameroon, Malawi and Angola.

Gold: Safe Haven or Hedge?

2007-04-22T12:35:00.000+02:00

"This paper analyzes the role of gold in financial markets. More specifically, it studies the question whether gold is a hedge or a safe haven for stocks or bonds. Our empirical results show that gold is a hedge and a safe haven for stocks in all markets for the entire sample period. However, gold is generally not a hedge or a safe haven for bonds in any market.
Moreover, gold only functions as a hedge and a safe haven in the short-run. In the long-run, gold is no safe haven, that is, investors that hold gold more than 15 trading days after an extreme negative shock loose money. The results also show that there is a large difference as to whether investors hold gold or purchase gold after an extreme negative shock occurred. In addition, since the price of gold in the US increases when stock prices fall, gold has the potential to compensate investors for losses with stocks thereby positively influencing market sentiment and the resiliency of the financial system."

Quoted from an interesting study available at SSRN: Baur, Dirk and Lucey, Brian M., "Is Gold a Hedge Or a Safe Haven? An Analysis of Stocks, Bonds and Gold" (December 2006).

Which Correlation?

2007-04-22T11:50:00.000+02:00

An anonymous reader noted that the correlation table I posted in 'Correlation in European Markets' a few days ago was the correlation of prices, and not the correlation of returns. This is correct. Now as having two different ways of calculating a correlation isn't confusing enough, let me add a third one: the Spearman Rank Correlation.

You're probably asking yourself which one is the 'best' - I had that question too. I wasn't able to find detailed comparisons, so the following is based on my personal analysis (so if you have some additional thoughts, please let me know):

The correlation of returns is a good indicator for reducing the short-term volatility of a portfolio. If one market zigs, the other one ideally zags. So if you're holding assets for several months or years and are viewing weekly correlations of returns, you can optimize (obviously based on historical data) the weekly volatility. This correlation doesn't tell you as much about the major trends as the other two correlations - one asset could have gone up, while the other one has gone down, and they still might have a high correlation of returns.

The correlation of prices is helpful when identifying 'sister stocks' that move in the same direction. It won't tell you that e.g. one of the two stocks (or ETFs) had a +200% performance and the other one only +20%. If this is what you'd want to know, you shoud take a look at 'cointegration' instead.

Finally, the Spearman rank correlation compares ranks instead of prices or returns - it tells you if two assets go up or down together over a longer term. This seems to be the best of the three correlations to optimize an asset allocation for the long term investors. If you're a daytrader or swing trader, ignore it.

I've updated the charts I posted recently and now have added the iShares S&P Euro 500 (IEV) and S&P 500 (^GSPC) to the table. Plus, you'll now find all three correlations calculated. Just pick the one you prefer.

Martin Armstrong and the February Crash

2007-04-19T12:02:00.000+02:00

Martin Armstrong, who's been sitting in prison for one of the largest securities fraud cases in US history has published some interesting theories back in the 90s. There are many conspiracy theories which I don't want to focus on, but instead on the crash on feb 28, 2007.

Armstrong's business cycles are based on pi*1000 days, or 8.6 years, which he's further dividing into quarter-cycle intervals of 2.15 years. He also combines six of the 8.6 year waves to a 51.6 year wave, and finally there's a 309.6 yr super-wave. Why is all this relevant? Back in 1999 he predicted the 8.6 year wave from late 2002 to mid 2011, with the market peaking on february 27, 2007. Now that's quite a coincidence, right?

Most of his online publications have disappeared in the past (simply because noone ever renewed the domains and ISP contracts), and he hasn't been able to publish anything since his imprisonment. Michael Alexander has based some of his work on Armstrong's publications and you might want to google him - in case you'll want to read more than the two publications from Armstrong I'm uploading to a free file hosting service (without knowing how reliable it is): The Business Cycle and the Future and What Tomorrow Will Bring.

Update: I just realized Armstrong has been sentenced to 5 more years only a few days ago.

Correlation in European Markets

2007-04-18T21:36:00.000+02:00

Have you ever asked yourself if investing in more than one european country reduces the volatility in your portfolio? The answer is easy: it doesn't. Here's a table with the weekly correlation of ten ETFs (all from iShares), based on the past three years - as you will notice, the average correlation is 98%:

So basically you have three choices: buy a single ETF that covers the entire western european market (ADRU, EKH, IEV, VGK,...), or focus on one or two countries that seem to have the best fundamental data. Or if you want to diversify currencies, then buy UK, Switzerland and one of the EUR countries - even if it won't matter much. Here's a performance chart:

One theoretical explanation for the high correlation that has come to my mind is that the majority of investors make a top down decision when investing in Europe (they simply buy a broad Europe fund/ETF), and the number of investors that actively trade certain stocks is negligible. Buying stocks in Europe simply isn't as easy (and common) as in the U.S. - without having any numbers, I guess less than one percent of all Europeans have ever purchased stocks.

In an upcoming post I'll try to compare european countries which might have less correlation - e.g. some eastern european countries like Turkey or Poland. If anyone has some specific ETF suggestions, please leave a comment in the next few days.

Bronson and the Equity Risk Factor

2007-04-17T03:00:00.000+02:00

Bob Bronson from Bronson Capital Markets Research has posted a great article regarding the Fed Model: "Quantifying and Forecasting an Equity Risk Factor", based on earnings, bond market's yield and the equity risk premium. He comes to the following conclusion:

"In other words, this alternate three-factor version of the model suggests the stock market will have to decline 39% to simply be normally valued, unless corporate earnings - very quickly - rise 65% or the 10-year T-Bond yield - very quickly - declines 39% to 2.84%, or some combination thereof – both very quickly."

He's expecting the P/E to drop to 8 within the next seven years and is also seeing an analogy between the war on islamic terrorism and WW1/WW2/Vietnam. This is probably as bearish as you can be - and even if you aren't, his arguments are solid.

Diversification by Trend Following

2007-04-16T23:39:00.000+02:00

SSRN has an interesting paper by William Fung and David Hsieh: "Asset-Based Hedge-Fund Styles and Portfolio Diversification" (October, 2001). Here's an excerpt:

"When the stock market is at an extreme, which tends to coincide with periods of high volatility, option prices rise resulting in the high positive returns of the asset-based trend-following style factor. During periods of high volatility, asset price movements are often amplified in magnitude. In addition, other studies have reported concurrent rise in price volatility across other asset classes when the equity market is under stress. Although the direction of price movement in other asset classes need not coincide with that of the stock market, the magnitude of price movements are often commensurate. It is the emergence of large price movements that provide trend followers with profitable opportunities.

In reverse, during steady periods in the stock market, the cost of being long options in periods of low volatility will lead to unfavorable performance of the asset-based trend-following style factor. By the same token, low volatility periods imply price movements of limited magnitude. This is an unfavorable environment to trend followers. In other words, the unusual return characteristic of trend-following strategies is a systematic consequence of large price volatility and not just an empirical regularity we found among trend-following funds. One immediate consequence of this is that trend-following funds contribute to portfolio diversification in a very specific way."

Dollar Depreciation and the New High

2007-04-16T22:14:00.000+02:00

The S&P 500 is making a new 6 1/2 years high - when priced in U.S. Dollar. How much of the current bull market has been a depreciation of the dollar? In October 2000 the Dollar Index (a select group of currencies, especially the euro) was hovering around 118.50, and these days it's falling below 82 - a 30% decline.

The U.S. economy is trying hard to restore external balance to a reasonable level and unwind its current account deficit, but for how much longer can other currencies bear the burden of this adjustment?

A quick note

2007-04-14T15:24:00.000+02:00

As you might have noticed, this blog is less than a week old. Not many people have visited the blog so far (900 visits, 1300 pageviews), so in case you like the content here and have a blog/site yourself, now might be a great moment to link to this blog or a specific article. Any kind of referral is highly appreciated. :)

Roughness and Beauty: Fractal Financial Markets

2007-04-14T13:20:00.000+02:00

The first time I heard about Benoît Mandelbrot was at the age of 15. I was watching my old Commodore Amiga calculating fractals. I had no clue that Mandelbrot had been analyzing stock markets since the 1950s to come up with a mathematical theory which would have a major impact on many aspects of the end of the 20th century (the chaos theory, 3D computer graphics in movies,...).

"To a man with a hammer, all problems look like a nail." - this was his simple comment after publishing "The (MIS)Behaviour of Markets: A Fractal View of Risk, Ruin and Reward" that attacked modern finance, Markowitz mean-variance portfolio optimization, Sharpe's CAPM, the Black-Scholes option pricing model, the random walk and the normal distribution. His claim is that all the patterns we see don't really exist and aren't more than an expression of randomness - and that price changes (like many other things) are self-similar when scaled. Now as Mandelbrot is Sterling Professor of Mathematical Sciences at Yale University and has been granted hundreds of awards, there might be a point, even if the theory sounds esoterical and is blowing up academic dogma.

Here's a brief example: according to a Gaussian description of prices, over the last 90 years the Dow Jones Industrial Average should have moved more than 3.4% during a single day only 58 times. It actually did so on 1,001 occasions. Before you start googling for terms like 'fat tails', 'skewness', 'kurtosis', 'pareto law', 'power distribution', let me mention a colleague of Mandelbrot: Nassim Nicholas Taleb, as they are collaborating on a general theory of risk management. Together they published an article in Fortune magazine back in 2005: "How the Finance Gurus Get Risk All Wrong", and now Taleb has published his book "The Black Swan: The Impact of the Highly Improbable". Here's a brief excerpt of the article mentioned above:

"Diversify as broadly as you can - far more than the supposed experts tell you now. This isn’t just a matter of avoiding losses: Long-run market returns are dominated by a small number of investments, hence the risk of missing them must be mitigated by investing as broadly as possible. Passive indexing is far more effective than active selection—but you need to go well beyond an S&P 500 fund to do yourself much good. And wherever you put your money, understand that conventional measures of risk severely underestimate potential losses - and gains."

As it's a saturday and markets are closed, you might have some spare time. Because then you could watch Mandelbrot's lecture at the MIT held in 2001: "Fractals in Science, Engineering and Finance (Roughness and Beauty)". Microsoft has another video lecture, but ignorant as they are, this video requires the use of Windows and Internet Explorer 6.0. Sorry, but I won't trade my Apple notebook for a Dell to watch it - I should probably short MSFT instead.

Lazy Portfolios and a US-Recession

2007-04-13T20:36:00.000+02:00

Most of the common lazy portfolios favour US assets or at least don't underweight them. In fact, they all are pretty similar. So if you're expecting a recession in the US in the next 12 months, like many others do, you might want to replace some of your ETFs by asset classes with a low correlation to the US equity market.

How many ETFs you'll end up holding might not matter a lot. With the strategy outlined below five won't be enough, but 8-12 should be fine. Also there's little reason for spending endless hours with mathematical formulas, comparing recent correlations etc - take a long walk instead and try to think about what's going to happen during a recession in the US (which might also be caused by a global account imbalance).

Some examples: any country that exports a lot to the US will directly be affected, while countries with a high domestic demand have less reason to worry about the current US account deficit. Brazil, India, Malaysia and South Africa all have large domestic markets, and also the European Union has reduced their net export to the US in the past years. Now add Australia which is mainly exporting commodities to Asia, and Japan, which has undergone a long recession in the past decade and now is seeing growing domestic demand (which only is party based on exports). You could also consider buying ETFs from Egypt, Turkey, Poland, South Korea, Norway, Sweden, Iceland, Estonia, Chile or Vietnam. While all these markets might see wild rides in the next years, they continue to have potential even during a global recession; you'd just have to keep them for a few years - and don't forget to rebalance when necessary.

Finally, and I hope I don't need to add long explanations, increase your exposure to commodities, real estate (e.g. in Asia), international bonds - and consider shorting the US dollar (e.g. via UDN).

Just be creative, buy the niches, and do some research.

Austria - a market full of risk?

2007-04-11T12:34:00.000+02:00

As I'm seeing more and more blogs mentioning the Austria ETF EWO, I'd like to add some notes that most US-based investors might not be aware of:

It's mainly a myth that Austria is the hub for eastern european countries (that joined the European Union in 2004). While it's true that some companies based in Austria have undergone recent expansions in these states, their influence on the local stock market is probably less relevant than a different development: after several decades of left winged federal chancellors the election in the year 2000 caused a major change in politics, as the conservative People's Party formed a coalition with the far-right Freedom Party. Over the following six years, they started a deregulation program, sold many of the formerly nationalized infrastructural assets, reduced taxes on assets, added tax reliefs for large companies, and did everything to reduce the deficit in the budget - obviously causing a major upswing of Austrian stocks (around 400% in the past few years).

The downside is that expenses in R&D, education, innovation and infrastructure have been cut dramatically in the past decade - which leaves Austria (which still is one of the richest countries in the world) in a bad prospect for the next decade: labor will relocate to cheaper eastern european countries, and European innovation is mainly taking part in Scandinavia (Nokia, Skype,...). Which is why in the long term Austria might be the most overvalued and riskiest market in Europe.

Commodity Index

2007-04-11T01:05:00.000+02:00

Judging by the DBC chart, commodities have been moving sideways for a while. The Reuters/Jeffries CRB Index looks even worse. On the other hand, Adam Hamilton from Zeal Intelligence notes: "The true CRB never broke down and instead broke out to achieve new all-time highs recently. There is nothing remotely bearish about the ninth-revision CRB's behavior over the past six months." - so what's the explanation for this statement?

In brief: the CRB has undergone its 10th revision in July 2005. Prior (1995-2005) it had 17 equally-weighted component commodities - orange juice was as important as oil. Since 2005, oil is now weighted with 23%. The basic composition is:

39.0% energy
21.0% tropicals
20.0% metals
13.0% grains
07.0% meat

Now to make things even more complicated, DBC has a different setup, and is based on only six commodities:

35.00% crude oil
20.00% heating oil
12.50% aluminium
10.00% gold
11.25% corn
11.25% wheat

In other words, its not easy to compare commodity indexes with each other, and especially over the long term. Which is why Adam Hamiltons notes on the CRB are worth a read: he discovered the Continuous Commodity Index (CCI), which is still based on the ninth revision (as of 1995) of the original Commodity Research Bureau (CRB) Index: "The bottom line is the Continuous Commodity Index, an extension of the old ninth-revision CRB's calculation methodology, components, and weighting, decisively shatters the false notion that there has been some catastrophic commodities breakdown. It is a myth. A new never-before-seen "CRB" index was driven lower by oil, but it wasn't the same index that made the secular uptrend in the first place by a long shot."

Bull market - or just inflation?

2007-04-10T19:49:00.000+02:00

Brett Steenbarger, Jan-Martin Feddersen, Barry Ritholtz and many others noted this long ago: the US bull market in the past years hasn't really been a bull market at all, but mainly a denomination of the dollar. While this isn't a real problem for US investors (yet), it has severe impact on portfolios in Europe or Asia: the majority of investors have a large position allocated to the US markets as most bread&butter funds are based on the MCSI World - so if they have a classic 60/40 portfolio, at least 30% of their entire capital have been moving sideways for years.

As any bull market is followed by a correction (even if it's an inflation bull market), and as there is little reason to believe the dollar will ralley against other currencies in the next 1-2 years, why would anyone maintain their position in the US market? If we'd go by "the best advise is to never lose money", we should all sit in cash, bonds, commodities, real estate and markets with a low correlation (japan, middle east, africa,...) while waiting for a major correction in the US/EU markets. So if you're bullish on the Dow, how bullish are you really?

Hindsight Bias

2007-04-10T15:09:00.000+02:00

A quick followup to my previous blog entry in which I had a link to aistockcharts.com: the site has some nice features (even though they are flawed a bit, unfortunately, and also I have no clue where the promised artificial intelligence is), but it's main problem is its hindsight bias. While it might be good to know which algorithms would have worked in the past, there's no easy way of telling if they might have stopped working. And/or, if they just happen to have worked for a very specific stock and time frame, or if they are usable universally.

Here's an example: "(faststo[14,3,k] < 8) and (newlow[50]) and ((macd[12,26,9] / ema[26]) < 0)" worked pretty well for SPY, QQQQ, AAPL, INTC and even NEW for several years. But, would you really want to use this timing strategy with your own money? I'm doubtful.

Hedge Funds

2007-04-10T07:26:00.000+02:00

Most people agree that hedge funds aren't a very smart way to invest your money due to the extreme management fees - so why do they still exist? Who's willing to pay 2&20? Is it just the dumb money that's being dumped into hedge funds?

Considering the fact that most asset classes currently have a very high correlation, there's at least one good reason to add at least a long/short hedging position to a broad long-only portfolio: reduction of volatility, with only little impact on portfolio returns. But do we really need to pay managers, or is it possible to create a personal hedge fund?

Very simple rules (such as "buy when MA20 is above the MA200, sell when MA20 is lower than the MA200") for a bunch of (leveraged) asset classes might not be very sophisticated, but sharpe ratio and returns might be better than investing in a hedge fund or hedge fund of funds. Sooner or later hedge fund fees will have to drop, or they might all close the doors.

The Overnight Premium

2007-04-09T23:08:00.000+02:00

The common assumption that holding an asset over night is risky seems to prove wrong. Brett Steenbarger from TraderFeed posted The S&P 500 Index and Its Multiple Personality, Dave from The Trading Digest has three followup posts with a backtest: holding the NASDAQ from 3/1/2000-3/1/2003 had an annualized return of -9.78% when buying at the open and selling at the close, and an annualized return of 7.98% when holding over night instead (1, 2, 3). And as a nice side effect: volatility is minimal. Unfortunately transaction fees would even render an ETF with this investing strategy impossible - would they?

Thomas Cover's Universal Portfolio

2007-04-09T22:49:00.000+02:00

CASTrader has a great summary regarding the Universal Portfolio (Cover 1991): a theoretical approach to a 'optimal' allocation by rebalancing daily and harvesting volatility on the go. Now as we all can guess, transaction costs would destroy the portfolio within weeks - but interestingly there are quite a number of studies that analyze real world implementations and possible algorithms.

It's a very academical approach, but if you've ever asked yourself which rebalancing interval is optimal (and if you're firm in math), this might be worth a read.

Mean Reversion

2007-04-09T22:24:00.000+02:00

Mebane Faber at World Beta has three interesting posts regarding mean reversion: Mean Reversion (Pt1), Mean Reversion (follow up) and Industry Mean Reversion. His conclusion is that the average time frame for mean reversion in the past 30 years was 2-3 years, regardless of country, industry or asset class. He's been able to create a yearly balanced portfolio (with only six asset classes) which had an average of 14% return with bond-like volatility in the backtest - which is very promising. His conclusion is:

"Now, we are certainly guilty of data mining. There has been ample academic evidence of both momentum and mean reversion in asset class returns. The big question is, will investors continue with the same behavioral biases as they have in the past, and at the same time frames? Will momentum at a years time frame continue while mean reversion exists at longer time frames of 2-3 years? That's the (multi)million dollar question. As long as humans continue to feel the same emotions of fear and greed as they have in the past, I am willing to bet that they do."

This might be a viable way to optimize the returns of a 'lazy portfolio' - especially if you're investing via ETFs and manage to keep fees down to a minimum. Unfortunately, while ETFs seem to be well known in the US, there aren't many in Europe - yet.

Information Overflow

2007-04-09T20:58:00.000+02:00

"The more we learn, the less we know" - I have to admit that there's a truth in these words. Having read thousands of blog posts (related to money management), lots of studies published on ssrn.com, newsletters, brochures and magazines in the past months, I still don't know where the Dow is going to be tomorrow. Or in a month. Or a year. At least I know that I'll never know.

Fortunately, I'm not the only one. Day for day people post their bullish or bearish sentiment. Some think commodities, real estate or emerging markets will continue to boom for years to come, others are sitting in cash and are fearing a world wide recession. A possible solution for that dilemma is a well diversified portfolio with low correlation between the asset classes. Buy and Hold. But, is any of the classic Lazy Portfolios a really good solution? How shall we deal with the problem of high correlation between all the asset classes? Aren't there any better strategies than the ones that were created 50 years ago?

It seems as if understanding Markowitz, Fama, French and all the others isn't enough these days. So let's listen to the crowd, to all the bloggers, the experts. Let's see what they suggest. This blog is an attempt to find at least some answers to the questions we all have.