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Trade Like A Chimp! Unleash Your Inner Primate

It is a long established fact that a reasonably well behaved chimp throwing darts at a list of stocks can outperform most professional asset managers. While there would be obvious advantages with hiring chimps over hedge fund traders, such as lower salaries and better manners, there are also a few practical obstacles to such hiring practices. For those asset management firms unable to retain the services of a cooperative primate, a random number generator may serve as a reasonable approximation of their skills. The fact of the matter is that even a random number generator can, and will, outperform practically all mutual funds. Such random strategies may seem like a joke, and perhaps they are, but if a joke can outperform industry professionals we have to stop and ask some hard questions. When designing investment strategies, it can be very useful to have an understanding of random strategies, how they work and what kind of results they are likely to yield. Given that random strategies perform quite well over time, they can act as a valid benchmark. After all, if your own investment approach fails to outperform a random strategy, you may as well outsource your quant modeling to the Bronx Zoo. Click to enlarge Meet your new boss. Portfolio Modelling Frequent readers of my articles (both of you) shouldn’t be surprised that we’re dealing with portfolio models here. A portfolio model is something very different from what most retail traders call a trading system. Oddly, the perception of trading system as a set of rules for timing buys and sells in a single market is still pervasive. That’s still what you tend to see if you ever pick up a trading magazine. That’s normally not how things look in reality of course. Not on the sharp end of the business. What we’re normally dealing with is portfolio models. In a portfolio model, the position level is of subordinate importance. The only thing that matters is how the portfolio as a whole performs. We’ll always have many positions on, and it’s the interaction of these positions that matter in the end. Portfolio modelling is a more productive way to spend your time. It would certainly be more useful in the asset management world. What may surprise some not in the industry is that often portfolio models don’t even bother to try any sort of entry and exit timing. Stop loss methodology is rare and concepts like position pyramiding would simply never be a topic. What we’re dealing with here are usually simple models, with mechanisms for selecting components, allocating to the components, rebalancing the components and of course benchmarking the result. Portfolio Model Benchmarking isn’t what it used to be Let’s start with that last point. Benchmarking. Every portfolio has to be measured against something. Very few professionals actually have the zero line as their benchmark. That’s what hedge funds are for. If you work in the industry, odds are that you have a specific index as your benchmark. We’ll go with one of the most common benchmarks here, at least for American equities; the S&P 500 Total Return Index. When you’ve got a benchmark index, you’re being measured against that. It doesn’t matter if you end the year +10% or -10%. It matters if you outperformed or underperformed the bench. At times it can be very comfortable to be measured relative to the index. It removes many difficult investment decisions. You gain and lose at the same time as everyone else. On the other hand, it can be frustrating when the markets are falling and you still have to be in. The index we’re using in this article, S&P 500 TR is different from the normal S&P index that you always see quoted. This is a total return index, meaning that all dividends are reinvested. The traditional S&P index is highly misleading over time, as the dividends appear as losses. So keep in mind that the S&P TR index will always show a better performance than the regular price index over time. In the long run, we’re all dead. Not too impressive, is it? Well, perhaps mutual funds can help. Mutual Funds Can’t Help The mutual fund industry is fundamentally flawed. There’s really no reason at all to ever, for any reason buy a mutual fund. If ever the internet memes about “You had one job…” fit any industry, this would be it. The mutual funds are tasked with tracking and outperforming an index. On average, around 85% of all mutual funds fail. How do I know that? The freaking SPIVA reports . A monkey would have a better chance. How can the Chimps Help? Professor Burton Malkiel once famously wrote in A Random Walk Down Wall Street that A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts. Now I think that’s highly unfair. After all, why would we want to blindfold the monkey? In what way would that contribute? As we all know, academic research has to be confirmed by empirical observation to be of much use. Ladies and gentlemen, I give you Ola the Ape. Back in early 90 when I was in business school in Sweden, we had a highly prestigious national investment championship. This was normally won by the famous analysts at the big investment banks. This was quite a big deal and getting a high ranking in this competition was a big career move. Then in 1993, somehow a chimp from the local Stockholm zoo got entered into the competition. Ola the Ape threw actual darts at the actual stock listings of the newspaper to pick his stocks. And he won. Amateurs! Random Simulations Unfortunately, our office chimp Mr. Bubbles has just accepted a higher offer from a competing firm, so I will have to resort to random number generators to prove this point. The first strategy we’ll test is something you’ve probably seen elsewhere. But we have to start somewhere. Here are the rules: We only pick stocks from the S&P 500 index. Historical membership accounted for of course. At the start of each month, we liquidate the portfolio and buy random stocks. We buy 50 random stocks for each new month. Each position is given an equal cash weight. Monkeys 1 – Index 0 Not too bad, is it? Not a single monkey failed to beat the index. But what’s going on here? Surely there’s a trick here? Let’s push this concept a little further and see if it falls apart. Our next simulation is even randomer. Yes, I’m sure that’s a word. The previous simulation had equal weighted position allocation. Perhaps that’s the trick. But would a monkey really allocate an equal amount to each stock? Or would he pick that at random too? Here’s our next simulation: We only pick stocks from the S&P 500 index. Historical membership accounted for of course. At the start of each month, we liquidate the portfolio and buy random stocks. We buy 50 random stocks for each new month. Each position is given a totally random allocation . Yes, we’re allowing any position sizes here. Perhaps a position is 0.0001% or perhaps it’s 99.99%. Let’s go wild. Monkeys 2 – Index 0 Ok, this is getting ridiculous. We’re still clearly outperforming the market. Not a single monkey loses against the index. Sure, there’s a lot wider spread here and that’s to be expected. There’s quite a large difference between the best monkey and the worst one, but they’re all better than the index and certainly better than the mutual funds. So where’s the trick? Is it the 50 stocks? Could this whole thing have to do with the magical number 50? After all, isn’t this a Fibonacci number ? And why would a monkey pick this number of stocks anyhow? Fine, let’s relax this one as well. Let’s do another one. We only pick stocks from the S&P 500 index. Historical membership accounted for of course. At the start of each month, we liquidate the portfolio and buy random stocks. We buy a random number of random stocks for each new month. Each position is given a totally random allocation . A random number of random stocks at random allocations. Now that’s how a proper monkey trades. Will the monkeys finally lose this time? Game, set and match. No. The monkeys still win. Now we see some really wild swings, but in the end our primate friends persevere. But now it’s really getting silly, isn’t it. What are we doing here that’s clearly working? Actually, it’s the other way around. The single largest positive factor is that we avoid making a mistake. That mistake being market capitalization weights. Simply by avoiding market cap weighting, we outperform. The larger issue here is benchmarking against an equal weighted index, such as the S&P 500. We all know that there are (approximately) 500 stocks in the S&P 500. But is that really true? Did you know that the top 10 stocks in that index has an approximate weight of 18%? And that the bottom 300 stocks also have a combined weight of about 18%? We’re all pretending that the S&P 500 is a diversified index, but it’s really not. It’s tracking a handful of the largest companies in the world and the rest really don’t matter. There’s practically no diversification in the S&P 500 To be fair to the index, and the index providers, I’d have to point out that indexes were not originally meant to be investment strategies. They were meant to measure the health of a market. As such, they’re not all that bad. But that doesn’t mean that you should invest like the index. It’s easy to check out equal weighting performs against market cap weighting. Just compare the S&P 500 Equal Weighted Total Return Index with the S&P 500 Total Return Index. Same stocks, same index provider, same methodology. Easy. Some stocks are more equal than others. In the random simulations above, we’ve seen that both equal weights and random weights are better than market capitalization weights. Obviously only a chimp would use random weights. Equal weights are quite common, though in my own opinion it makes much more sense to use volatility parity weights. That’s nowhere near as complicated as it sounds. Vola parity just means that we size our positions according to inverse volatility. A more volatile stock gets a smaller allocation. Why? Because if you put an equal amount of cash in each stock, your portfolio will be driven by the most volatile stocks. If you buy a utility stock and a biotech, the biotech stock is likely to be the profit and loss driver of the portfolio. An equal weight in the two would mean that you put on more risk in one stock that the other. Vola parity weighting means that you, in theory, put on equal amount of risk in both stocks. Yes, I deliberately used the word risk here so the comment field will be filled up with quants pointing out that I don’t understand risk. Go ahead. I’ll wait. Let’s do one more of these funny simulations before getting to the real stuff. We only pick stocks from the S&P 500 index. Historical membership accounted for of course. At the start of each month, we liquidate the portfolio and buy random stocks. We buy 50 random stocks for each new month. Each position is given a volatility parity allocation . Best monkeys so far. This looks pretty good, doesn’t it? Now we have better performance and more importantly, a narrower span of performance. The monkeys all do really well and there’s not all that much difference between them. If only we could figure out a way to be one of those better chimps. Let’s be the better primate! Why should the chimps get all the fun? Clearly these guys know how to trade, but perhaps we can figure out a way to beat them. We’ll have to take out the random factor and find a better way to pick our stocks. The volatility parity seems to work though, and so does the monthly rebalancing. We’ll keep those. There are several valid ways of picking stocks. You could use value factors, dividend yield, quality, momentum etc. I’m going to use momentum here, because clearly it’s the best one (not at all because I wrote a really neat book on that topic ). Besides, it’s the easiest one to quantify and model. The data is more readily available and so are the tools needed. Here’s our new, chimp free simulation: We only pick stocks from the S&P 500 index. Historical membership accounted for of course. Trading is done monthly only. Rank stocks based on Clenow Momentum™ . If cash is available at start of month, buy from top of ranking list until no more cash. Inverse vola position sizing, using ATR20. Sell at start of month if stock is no longer in top 20% of index or if Clenow Momentum ™ is lower than 30. Some may recognize this as a simplified version of the one presented in Stocks on the Move . It’s much simpler, but performs in a very similar manner. It has slightly deeper drawdowns and slightly higher return. Those of you who didn’t read Stocks on the Move, may wonder what a Clenow Momentum is, and whether or not I’m joking about that name. Step one, put my name on stuff. Step two, get a comb-over. The Clenow Momentum ™ is clearly a silly name for a pretty decent analytic. This is just an improved way of measuring momentum. First we take the exponential regression slope, instead of the linear, since it’s measured in percent and can therefore be compared across stocks. It will tell us the slope in percent per day, which will give you a number with too many decimals to keep track of. So we annualize it get a number that we can relate to. Now the number tells us how many percent per year the stock would do, should it continue the same trajectory. But the annualized exponential regression slope doesn’t say anything about how well the data fits the line. The coefficient of determination, R2, does. That’s a number between 0 and 1, where a higher value means a better fit. If we multiply the two, we essentially punish stocks with high volatility. And there you go. Clenow Momentum ™! Not too bad for a human! Now we’re seeing some interesting results! Even without the help of the chimps, we’re now clearly outperforming the bench. It’s a consistent outperformance too, during both up and down markets. The reason that we outperform in bear markets is that we don’t buy stocks with a low absolute momentum value. When there are no stocks moving up, we don’t buy any. This all seems good and well, but I’m sure you’re all wondering about the most important point. How did we do against the chimps? You can’t beat all the chimps. We may not be the best primate, but we’re certainly among the smarter ones! Being in the upper 5% of the chimps is pretty good. On the evolutionary scale, we have now moved beyond the mutual fund managers, beyond the index itself and we’re competing with the best of the chimps! So what’s the point here? There are several important learning lessons from all of this. Perhaps the best way to summarize it would be to paraphrase Gordon Gekko: The point, ladies and gentlemen, is that chimps are good. Chimps are right. Chimps work. Chimps clarify, cut through and capture the essence of the evolutionary spirit. Well, with all due respect to Gekko the Great, perhaps there are better ways to sum this up. Random models reveal the weakness of index construction. Benchmarking against random models help you put your own results into context. Does your portfolio model really add value, or is it just another chimp? It’s very easy to make a simulation that beats the index. Systematic momentum investing is likely to beat the index, and most of the chimps. You will never beat all the chimps. The recent book Stocks on the Move, incidentally written by yours truly, contains a more in depth analysis of how momentum strategies can be used to outperform the benchmark. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: No chimps were harmed in the production of this article.

Infrastructure, Dividends And Path Dependence

A new paper from EDHEC Infrastructure Institute-Singapore argues that infrastructure firms represent a unique business model, one with lower revenue volatility, higher payouts, and substantially lower correlation with the business cycle than other firms. An “infrastructure firm” for purposes of this discussion is either a special purpose vehicle created in the context of a specific infrastructure project; a firm that conducts specific infrastructure-related activities, such as a port or an airport; or a regulated utility. Along the way to making its points, the paper also speaks, if only briefly, to an idea at the core of behavioral economics and finance: path dependence. But more of that in time. Investors and Regulators EDHEC infra prepared this paper in partnership with the Long-Term Infrastructure Investors Association, an organization of investors with a sum of $5 trillion in assets under management. In a press release that accompanied the paper, LTIIA chairman and CEO Thierry Déau said: “Not only can this research benefit investors in their profile decisions; it can also help build a deeper alignment between infrastructure investors and regulators.” The publication, “Revenue and dividend payouts in privately-held infrastructure investments,” by Frédéric Blanc-Brude, Majid Hasam, and Tim Whittaker, focuses on firms situated in the United Kingdom, because the UK offers “the largest, longest and most coherent set of infrastructure cash flow data available at this time.” Also, by confining the study to a single currency and regulatory environment, the authors avoid the need to control for those dimensions in their analysis. Six Conclusions Each infrastructure firm in the EDHEC infra database was, for purpose of this study, matched with a “nearest neighbor” non-infrastructure firm for control purposes. The matching was based on total asset size, leverage, and profitability. As a consequence of their statistical analyses, the authors came to six conclusions: Infrastructure firms have lower revenues and profits per dollar invested than the paired firm; They have significantly lower volatility of revenues and profits, in the aggregate and “at each point in investment and calendar time”; Infrastructure firms have a dynamic lifecycle, that is, the unit revenues and profits evolve by an order of magnitude over the investment cycle; Their revenues and profits are not tied, or at worst not closely tied, to the business cycle; The probability of positive equity payouts is high; finally; Equity payout ratios and considerably higher than in the relevant control groups. Trading one Cycle for Another The third and fourth of those points are closely related. One might roughly say that because infrastructure firms tie their fate to their own lifecycle, they gain some independence of the business cycle. Statistically speaking, four proxies of the business cycle highly correlated to one another [calendar year dummies, GDP, retail prices, and the Fama-French market factors] “have limited or no explanatory value with respect to the variance of revenues in infrastructure assets….” Thus, infrastructure can serve a portfolio manager as a powerful diversifier. It is in considering the equity payout process, referenced in the fifth and sixth of the bullet points above, that we come to the issue of path dependence. Path dependence is a concept developed within the subculture of behavioral economics. It refers to the sometimes nonrational and generally unanticipated ways in which later choices are affected by earlier choices. One classic example is the continued use of the QWERTY keyboard in all sorts of devices and virtual displays today, though its creation in the early days of the typewriter is shrouded in mystery. Joan Robinson anticipated the development of the idea of path dependency in the 1970s, when she wrote, “Once we admit that an economy exists in time, that history goes one way, from the irrevocable past into the unknown future, the concept of equilibrium … become untenable.” Robinson believed that path dependence was so important that it required a rethinking of the foundations of economics as a science. Blanc-Brude et al have no need to go that far. They do observe, though, that there is strong evidence of path dependency in this respect: “those [infrastructure] firms that begin to pay dividends early their life are more likely to be paying dividends later on.” This is odd, because infrastructure firms are “private firms with concentrated ownership.” The usual explanation for path dependence, that is for “stickiness,” in the level of dividend payouts, is premised upon publicly listed firms and/or distributed ownership. Stickiness is said to mitigate the agency costs inherent in the relationship between a small management group and a large ownership group. So: why do infrastructure firms, for whom the agency cost explanation doesn’t fit, nonetheless show this path dependency? The study gives no definitive answer to that question, beyond the suggestion that such a constant payout path in a standalone infrastructure product “could be interpreted” as a measure of the project’s success. It seems a fitting topic for further research.

Reasons To Bet On Gold Mining ETFs Now

Gold Mining ETFs have been firing on all cylinders lately thanks to the dual favor by a dovish Fed and an aggressive China. The Fed seems to be in no hurry to hike interest rates this year and has hinted at just two hikes this year dampening the greenback and propelling the broader commodities including gold. In fact, a volatile market outlook, which is making places for safe-haven assets like gold and a sagging dollar, led the gold bullion to rally hard this year. Gold bullion ETF SPDR Gold Shares (NYSEARCA: GLD ) has surged 18.3% so far this year (as of April 11, 2016), enjoying the largest first-quarter gain in three decades. Along with the underlying metal gold, gold mining ETFs also put up great gains as these often trade as leveraged plays on gold. Plus, Chinese gold miners are hunting for lucrative foreign acquisitions thanks to lower gold prices so that they can acquire assets at a bargain, as per Wall Street Journal. Wall Street Journal also reported that “if cash-rich Chinese gold miners embark on an asset-buying spree, China could reduce its dependency on other international producers for supplies and increase its heft in global gold markets. Since many global gold mining companies are facing hard times due to years of low gold prices, these are appearing as lucrative acquisition targets of Chinese buyers. China is the world’s top gold consumer, accounting for about one-third of the global demand. So, its interest in gold acquisition is self-explanatory. In 2015, Barrick Gold Corporation (NYSE: ABX ) offloaded a 50% interest in Barrick (Niugini) Limited (BNL) to Chinese mining company Zijin Mining Group Co. Ltd. ( OTCPK:ZIJMF ) for a total cash consideration of $298 million. Apart from Zijin, another company Zhaojin Mining Industry Co. Ltd. ( OTCPK:ZHAOF ) is mulling over the idea of an overseas gold mining acquisition, as per Wall Street Journal. Several gold mining ETFs hit a 52-week high on April 11. Among them, we highlight five ETFs below that exhibited strong pricing gains. The Weighted Alpha of most of these ETFs hovered around positive 50 , indicating the possibility of further gains. Global X Gold Explorers ETF (NYSEARCA: GLDX ) The fund seeks to match the performance and yield of the Solactive Global Gold Explorers Index. The $39.2-million ETF charges 65 bps in annual fees and has a dividend yield of 7.58% (as of April 11, 2016). First Mining Finance ( OTCQB:FFMGF ), Seabridge Gold (NYSE: SA ), and Oceanagold Corp. ( OTCPK:OCANF ) command the top three positions in the basket. Market Vectors Junior Gold Miners ETF (NYSEARCA: GDXJ ) This one tracks the Market Vectors Junior Gold Miners Index, which provides exposure to small- and medium-capitalization companies that generate at least 50% of their revenues from gold and/or silver mining. The $1.97-billion product charges 55 basis points in annual fees with a paltry annual dividend yield of 0.46%. B2Gold Corp. (NYSEMKT: BTG ), Alamos Gold Inc. (NYSE: AGI ) and Centamin PLC ( OTCPK:CELTF ) occupy the top three positions in the 49-stock fund. ALPS Sprott Junior Gold Miners ETF (NYSEARCA: SGDJ ) SGDJ seeks to deliver exposure to the Sprott Zacks Junior Gold Miners Index. Each stock’s weighting in the index is based on two factors, namely revenue growth and price momentum. The $34.3-million ETF charges investors 57 basis points on an annual basis. Among individual holdings, Sibanye Gold Ltd. (NYSE: SBGL ), Detour Gold ( OTCPK:DRGDF ) and Tahoe Resources (NYSE: TAHO ) occupy top three spots in the fund. iShares MSCI Global Gold Miners (NYSEARCA: RING ) The fund seeks the MSCI ACWI Select Gold Miners Investable Market Index. The $103-million ETF charges 39 basis points a year. The fund currently has 29 companies in its basket, with the top stocks being Barrick Gold Corp. ( ABX ), Newmont Mining Corp. (NYSE: NEM ) and Goldcorp Inc. (NYSE: GG ). Sprott Gold Miners ETF (NYSEARCA: SGDM ) SGDM tracks the Sprott Zacks Gold Miners Index, which is a rules-based index that assigns weighting to a stock on the basis of fundamental factors like revenue growth and balance sheet strength. This $173-million ETF charges 57 bps in fees. The fund currently holds 25 stocks. Among individual holdings, Franco-Nevada Corporation (NYSE: FNV ), Goldcorp Inc. ( GG ) and Agnico Eagle (NYSE: AEM ) comprise 40% of the portfolio. Original Post