Tag Archives: brian-haskin

Adding A Defense To A Value And Momentum Offense

By DailyAlts Staff The concept of combining value and momentum investing to create more durable equity portfolios has really caught on as of late, with recent coverage from Barron’s and a white paper from Research Affiliates extolling the virtues of the combined strategy. Meb Faber of Cambria Investment Management has also chimed in with a paper of his own : “Learning to Play Offense and Defense: Combining Value and Momentum from the Bottom up, and the Top Down.” Mr. Faber’s view is that value and momentum can be combined for offense, but even more care needs to be taken on the defensive end of investing. The Importance of Defense Mr. Faber relays a story from his high-school football days to express the importance of defensive investing. To rally the defensive unit, Mr. Faber’s old football coach would tell the players that nobody ever lost a game by a score of 0 to 0 – thus, if the defense did it’s very best, the odds of the team losing were practically nil. The same can be said of investing, where protection against drawdowns of 50% or more is probably more than “half the game.” Offensive Playbook That said, no one ever won a game with a score of 0 to 0 either, so in order to have investment success, your portfolio is going to need to “score some points.” Mr. Faber favors a combined value/momentum approach, since the two styles have been proven to add value over time, and they have the added benefit of being inversely correlated. Put simply, the value/momentum offensive playbook consists of two rules: Invest in cheap stocks (value) Invest in stocks that are going up (momentum) Offensive Methodology How should one measure a stock’s “cheapness” or select an appropriate time frame for determining bullish price momentum? The details aren’t all that important, in Mr. Faber’s view, since cheap stocks are likely to be cheap by most or all sensible measures, and the same can be said of the bullish price momentum of good candidates for the momentum half of the playbook. Nevertheless, Mr. Faber’s own methodology for determining cheapness involves price-to-earnings and price-to-book ratios, as well as EBIT (earnings before interest and taxes) divided by total enterprise value (market cap plus debt.) His momentum methodology looks at price movements over the past three, six, and twelve months. From there, the top 100 qualifying value and momentum stocks are added to a portfolio and rebalanced every three months. This combined “VAMO” (value + momentum) portfolio has outperformed the S&P 500 by a significant margin since 1964. Defensive Strategy Despite VAMO’s dramatic besting of the S&P 500 over the past half-century, the strategy did suffer a larger maximum drawdown of 56.05%, compared to the S&P 500’s worst of 50.95%. If you have the capital and temperament of Warren Buffett or his partner Charlie Munger, these drawdowns are just good opportunities to add to positions, but for most of the rest of us, big selloffs like we saw in 2008 can be stress-inducing and cause us to sell at the worst possible times. That’s why Mr. Faber prefers combining VAMO with a defensive strategy designed to mitigate those maximum drawdowns. Its two-rule playbook is simple: Don’t invest in stocks when the broad market is expensive Don’t invest in stocks when the broad market is going down Conditions for rule #1 are satisfied when the broad market’s P/E ratio is in the top 20% of its historic valuation range. Rule #2 is in effect whenever the S&P 500 is trading beneath its long-term moving average. When either set of conditions are apparent, the “VAMO Hedge” strategy initiates a short position in the S&P 500 equal to half of the VAMO portfolio’s size. When both conditions are met, then the VAMO Hedge strategy becomes “market neutral,” with shorts on the S&P 500 equal in size to the VAMO portfolio’s long holdings. The results? A surprisingly lower annualized return, but a much smaller maximum drawdown combined with lower volatility, and therefore a superior Sharpe ratio. If you have the stomach of Warren Buffett and Charlie Munger, perhaps you can do without this hedge. Otherwise, combining value and momentum with Mr. Faber’s hedging strategy appears to be a prudent means of maintaining market exposure while protecting against downside risk.

Is It Time To Short Small-Cap Stocks?

By DailyAlts Staff Size matters to factor-based investors, as small-cap stocks have historically outperformed their large-cap counterparts. But throughout the equity market’s history, there have been periods of dramatic small-cap underperformance, and David Schulz, president of Convergence Investment Partners, thinks we may be headed into such a period. He and his team at Convergence are rare among small-cap managers in employing an active shortin g strategy as both a source of alpha and a way to reduce risk. The Convergence Opportunities Fund (MUTF: CIPOX ) reflects the views of Mr. Schulz and his team. The fund, which debuted in November 2013 and ranked in the top 9% of funds in its category in its first calendar year, lost 5.4% in the first nine months of 2015, but still ranked in the top quartile of its peers. Going forward, the fund should outperform if small caps underperform, providing a unique way for investors to diversify their portfolio risks. Why are Mr. Schulz and Convergence bearish on small caps? The firm sent out an alert late last month citing a variety of reasons pertaining to valuation: Roughly 27% of stocks in the small-cap Russell 2000 index have negative P/E ratios (i.e., they’re unprofitable), while this is true of only 8% of large- and mid-caps in the Russell 1000; About 9% of Russell 2000 stocks have a P/E ratio of 50 or higher, while less than 6% of Russell 1000 stocks have such high earnings multiples; and In total, 36% of stocks in the Russell 2000 have P/E ratios that are either negative or over 50 – and 10 stocks in the index have P/Es that are over 1000! Furthermore, increased volatility in the equity markets has been bearish for small caps, since conditions have led investors to “sharpen their focus on valuations,” in Convergence’s words. In the brutal month of August, the 25 small-cap stocks with the highest P/E ratios returned -8.83%, while the 25 stocks with the lowest P/Es returned -0.28%. Since there are many more small caps with high P/Es than with low valuations, this trend is bearish for small caps in general, but Convergence’s Opportunities Fund applies a long/short approach to capture the upside exposure to the best-valued small-cap stocks. The firm says so-called “hope stocks” are on its list of shorts – these are companies with “weak balance sheets; low or decelerating cash flow, earnings, and sales; and high expectations.” Convergence believes an active short portfolio can complement an active long portfolio, especially during particularly tumultuous times. The short portfolio can “cushion the fall” when the market is under pressure and “add materially to the overall return of the portfolio over time.” Ultimately, stocks are differentiated by their fundamentals, and with interest rates expected to rise soon, the most fundamentally sound companies should outperform those with weaker balance sheets and decelerating earnings. The Convergence Opportunities Fund seeks to capitalize by applying a flexible long/short approach to U.S. small-caps. Share this article with a colleague

Franklin K2 Launches Second Multi-Manager Alternative Fund

By DailyAlts Staff Franklin Templeton Investments’ 2012 acquisition of K2 Advisors gave the firm a significant foothold in the alternative investments arena. Since then, Franklin Templeton has relied upon K2’s expertise in the hedge fund space to launch a ’40 Act fund, the Franklin K2 Alternative Strategies Fund (MUTF: FAAAX ), which debuted November 2013. More recently, K2 founder David Saunders “solidified” his case for liquid alternatives . And now the firm has announced the launch of another ’40 Act alternative fund: the Franklin K2 Long Short Credit Fund (MUTF: FKLSX ). “For investors looking to complement their overall portfolios with a diversified, multi-manager approach with less correlation to traditional long-only fixed-income holdings, we believe this Fund can be an important tool,” said Mr. Saunders, the co-lead portfolio manager of the fund in addition to being K2’s founder, in a recent announcement. Fund Overview The Franklin K2 Long Short Credit Fund is a multi-manager fund that invests in a variety of credit strategies sub-advised by institutional quality hedge fund managers. The fund therefore provides retail investors with access to managers that may otherwise be unavailable to them. The fund’s objective is to provide total return, through a combination of current income and capital appreciation, over a complete market cycle. Capital preservation is also part of the fund’s objective. K2 pursues these ends by continually adjusting allocations to the sub-advisors, based on the top-down market views of the fund’s portfolio managers. In addition to Mr. Saunders, they include head of investment research Robert Christian, managing director of portfolio construction Jeff Schmidt, and managing director Charmaine Chin. Manager Structure The sub-advisors – which include Apollo Credit Management, Candlewood Investment Group, Chatham Asset Management, and Ellington Global Asset Management – employ credit long/short, structured credit, and emerging-market fixed-income strategies. The investments used by the sub-advisors may include: Corporate bonds; Mortgage-backed securities and asset-backed securities; S. government and agency securities; Collateralized debt and loan obligations; Foreign government and supranational debt securities; Loans and loan participations; Mortgage dollar rolls; Repurchase agreements and reverse repurchase agreements; and Mortgage REITs. By diversifying across asset classes and strategies, the Franklin K2 Long Short Credit Fund – like the Franklin K2 Alternative Strategies Fund before it – aims to dampen portfolio volatility and provide lower correlation to traditional long-only fixed-income strategies. K2 makes its allocations to the underlying managers, who then execute high-conviction long and short positioning in pursuit of the fund’s objectives. “With credit spreads tight relative to historical averages, investors may not want as much credit risk exposure by being long-only high yield or investment grade debt, and may want a more flexible long/short approach,” said Franklin Templeton Solutions head Rick Frisbie. “In a potentially rising rate environment, U.S. investors who invest in fixed income for diversification and risk mitigation purposes are potentially taking on more interest rate risk than their goals would dictate and may be open to looking for new ways to diversify their portfolio.” For more information, visit franklintempleton.com .