Tag Archives: performance

Risk? What Risk?

By Dominique Dassault Equity Risk Is Increasingly Non-Existent… By The Numbers The concept of risk for hedge fund managers is a constant concern. The internal monologue goes something like this…”what’s my downside if I initiate this position… how much can I lose if I am not right?” The real answer is that you really have no idea… despite best efforts… even with stop losses [which I abhor]. The true, measurable risk of any position is only exactly known after you liquidate the position. Plus, risk management is more capital management than single stock management. Little did he know how it would all end… Cartoon via wallstreetsurvivor.com How much capital are you assigning to each position in the context of the entire portfolio capital? And are your different positions correlated or not? Even if they are [not], historically, there is no guarantee that correlation [or not] will continue. Anyway… back to risk. Every day my prime broker blasts me with a report loaded with scores of trading metrics calculated over many time frames [mostly the last twelve months]. It is all very interesting but the only real metrics I care to focus on are total returns and risk-adjusted returns. Most clients could not care less about risk-adjusted returns… but I sure do. And, as many are aware, the holy grail of risk metrics is the Sharpe Ratio [as calculated according to the title of this post]. The most interesting precept of the Sharpe Ratio, in my opinion, is that it treats volatility as random… both upside and downside volatility. No way to predict it in either direction so both directions are assigned the same discounting value. Basically, according to Bill Sharpe, all volatility is a penalty against your performance. I get it. Still, in a perfect world, what if most of the volatility experienced by a portfolio of equities was actually favorable? So rare… if not impossible… but still at least worthy of consideration. And so the Sortino Ratio [or as I refer to it as the Gain/Pain Ratio] was born… essentially, it is exactly as the Sharpe Ratio but stratifies favored and unfavored volatility. Favorable volatility is not penalized. Unfavorable volatility is scored as a legitimate demerit. It has always seemed fairer to me. (click to enlarge) The difference between the Sharpe and Sortino ratios Naturally, both ratios are relevant and higher values for both measurements reflect better risk-adjusted returns. And portfolio managers realize that, no matter the ratio, both need to be positive…or you are losing money. However, given full investment of capital, the Sharpe Ratio can be strongly positive yet still not offer high absolute returns. Conversely, if your Sortino Ratio is high, you are probably delivering very strong absolute returns… again, assuming full investment of capital. An Era of Painless Gains Given all of this… What is a good numerical value for both ratios? Generally, over time, any value > 1.5 is pretty good and numbers > 2.0 are stellar. Be advised the data may vacillate, a little bit, based on the time frame used in your calculation i.e. weekly or monthly. Recently, I constructed a model that required one, three and five-year Sharpe Ratios for the S&P 500. I also decided to include the Sortino Ratio. Prior to the results, I hypothesized that the numbers ought to be pretty impressive given the endless equity “bull” since March 2009, but I was still curious to get the exact data. Plus, a weekly price chart of the S&P 500, since 2009, visually reflects the anomaly of very limited drawdowns in the context of extremely strong returns. The calculations are as follows and as Mrs. Doubtfire once said…”Effie… Brace Yourself.” Sharpe Ratio 1-Year = 1.37 3-Year = 1.86 5-Year =1.0 Sortino Ratio 1-Year = 2.65 3-Year = 3.41 5-Year = 1.69 Collectively, these numbers are clearly impressive but even more so in that they are calculated from a passive, long only strategy. This is a hedge fund manager’s worst nightmare as, for five years, most “hedging” has proved to be only performance degrading. (click to enlarge) S&P 500 index – since the 2009 low, hedging has essentially just been a performance drag, with the possible exception of the 2011 correction. Furthermore, the Sortino Ratio data are nothing short of staggering. What they really say = Plenty of Gain with Very Little Pain … and it really is unsustainable if only because it has become much too easy to generate positive returns with very little effort, pain or savvy. To the Ignorant the Spoils It actually seems, at times, as though there is this mysteriously large buyer that suddenly appears whenever the equity market most “needs it”… and the subsequent buying is so aggressive and so desperate… not the style of the mostly steady “hands” I personally know. It just seems too good to be true and the Sortino Ratio numerically reflects that belief. Plus, we all know that the economic fundamentals are not as smooth as the weekly or monthly charts of the S&P 500 would suggest. Remember that equities typically offer the most risk of any asset class… not the lowest risk as the above data set suggests. Nevertheless, Yellen and Bernanke must be “psyched” as their “wealth effect” model has been so effective… actually too effective as the market distortions grow ever larger… and more market bears become contorted “road-kill.” To be sure these distorting effects may be entirely assigned to The Fed… the debt monetizing, interest rate suppressing “Masters of the Universe” who always get what they want while answering to nobody. They’ve literally trounced and expectorated on the concept of “moral hazard” and, it seems, purposely reconfigured and redefined its meaning into: We have no economic morals and this poses an enormous hazard to the performance of hedged money managers. The spoils go to the ignorant only – the Fed’s true heroes. Charts by: Advisor Central, BigCharts

TAO: Real Estate In China Offers More Risk Than Returns

Summary TAO has been fairly volatile and feels even more dangerous to me because I’m bearish on China. Due to a low correlation with SPY, TAO would appear to fit reasonably in a diversified portfolio. The long term challenge for TAO is very high expense ratios that eat into any returns the ETF produces. Despite a high expense ratio, the holdings are fairly concentrated which may be one reason for the high volatility on the ETF. The Guggenheim China Real Estate ETF (NYSEARCA: TAO ) seeks to track the performance of the AlphaShares China Real Estate Index. I have to admit that I’m biased in looking at TAO as an investment because I’m a large bear on China. I believe equity values have been moving too high and domestic retail investors are holding meaningful positions in the Chinese equity market. If the market turns south it won’t just be a loss of equity valuations, it will mean less cash available for the domestic investors to spend on their other life expenses. In my opinion, that compounds the problem of holding exposure to China. Risk When measuring the historical volatility of investments in the SPDR S&P 500 Trust ETF ( SPY), the monthly standard deviation of returns has been almost twice as high as the deviation for SPY since the start of 2008. On the other hand, the correlation on monthly returns was only 65.5% which is fairly attractive. I put together a chart showing the changes in risk between holding a position that is simply invested in the S&P 500 versus mixing some TAO into the portfolio. (click to enlarge) Despite the very high level of risk for TAO, the low correlation does help it fit within the context of a portfolio. I’m not big on investing in China, but for investors that want to buy REIT exposure in China the added volatility at 5% of the portfolio isn’t too bad. Liquidity is challenging The average trading volume is only around 90,000 shares per day. If looking to invest in TAO, I would be applying a liquidity premium to the minimum acceptable level of expected returns. Yield The distribution yield is 2.33%. For being classified as real estate, the distribution is not as high as I would like to see it. When you see high volatility, low liquidity, and weak yields it is creating the perfect storm for investors to lose part of their portfolio since panic in selling could result in some fairly awful prices being realized. Expense Ratio The gross expense ratio is .95% and the net expense ratio is .71%. Simply put, that is way higher than what I am willing to pay on any ETF investment regardless of the exposure. These niche investment areas can result in fairly weak competition and fairly high expense ratios. Largest Holdings The diversification within the portfolio is fairly weak. Just over 50% of the value of the portfolio came from the top 10 holdings. (click to enlarge) Conclusion I’m bearish on China and I’ve found an international REIT ETF that offers investors high volatility, high expense ratios, and only moderate levels of diversification. It’s too bad investors can’t actually short stocks with no trading costs the way economic theory suggests. With such a high expense ratio it would be tempting to short the ETF and go long the underlying stocks to obtain the alpha from avoiding the expense ratio. Too bad it doesn’t work like that in the real world. That leaves me with no better option than just avoiding this investment. I wasn’t bearish on China a year ago. When the prices were more reasonable, I had no problem with exposure to the Chinese equity market. On fundamental valuations the market may not seem too bad, but any weakness could hurt the consumers which would hurt the fundamentals of the companies. If the prices fell far enough after adjusting for declining fundamentals, I wouldn’t mind buying exposure to China again. However, if I did that I would still be looking to get that exposure with a much lower expense ratio. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

The Low Volatility Anomaly And The Delegated Agency Model

Summary This series offers an expansive look at the Low Volatility Anomaly, or why lower risk stocks have historically produced stronger risk-adjusted returns than higher risk stocks or the broader market. This article hypothesizes that the combination of a cognitive bias and an issue around market structure could contribute to the Low Volatility Anomaly. This article covers a deviation between model and market that may contribute to the outperformance of low volatility strategies. In the last article in this series , I demonstrated that the aversion of certain classes of investors to employing leverage flattens the expected risk-return relationship as leverage-constrained investors bid up the price of risky assets. In addition to the inability to access leverage for long-only investors, the typical model of benchmarking an institutional investor to a fixed benchmark (i.e. the S&P 500 represented through SPY ) could also potentially produce a friction to exploiting the mispricing of low volatility assets (represented through SPLV ). If a security with a beta of 0.75 produces the same tracking error as a security with a beta of 1.25, investors may be more willing to invest in the higher beta security with the belief that it is more likely to generate higher expected returns per unit of tracking error. In this framework, if the investor believes that the higher beta security is going to deliver 2% of alpha and that the higher and lower beta assets are going to have the same tracking error relative to the index, then the investor would not purchase the lower beta asset unless it was expected to earn alpha of more than 2%. An undervalued low beta stock with a positive expected alpha, but an alpha below the expected alpha of a higher beta stock with an equivalent expected tracking error, would be a candidate to be underweight in this framework despite offering both higher expected return and lower expected risk than the broad market. This investor preference results in upward price pressure on higher beta securities and downward price pressure on lower-beta securities that could be a factor in the lower realized risk-adjusted returns of higher beta cohorts depicted in the introductory article in this series . In a foreshadowing of the next article on the potential influence that cognitive biases have on shaping the relationship between risk and return, the difference between absolute wealth and relative wealth could be an important distinction that influences the behavior of delegated investment managers. Richard Easterlin (1974) found that self-reported happiness of individuals varied with income at a point in time, but that average well-being tended to be very stable over long time intervals despite per capita income growth. The author argued that these patterns were consistent with well-being depending more closely on relative income than absolute income. This preference for relative outperformance rather than absolute outperformance may signal why some managers think of risk in terms of tracking error rather than absolute volatility. In perhaps a more salient example, Robert Frank (2011) illustrated the relative utility effect through an experiment that showed that the majority of people would rather earn $100,000 when peers were earning $90,000 than earn $110,000 when peers were earning $200,000. Among the assumptions underpinning CAPM is that investors maximize their personal expected utility, but these studies suggest that investors in effect seek to maximize relative and not absolute wealth. Similar to leverage aversion detailed in the last article, the preference for relative utility could be another CAPM violation that contributes to the Low Volatility Anomaly. Gauging performance versus a benchmark is a form of maximizing relative utility, and has become an institutionalized part of the investment management industry perhaps to the detriment of the desire to capture the available alpha in our low beta asset example. I am not trying to minimize tracking error in my personal account, I am trying to generate risk-adjusted returns to grow wealth over time. As I have demonstrated in this series, academic research has shown that low volatility stocks have outperformed on a risk-adjusted basis since the 1930s. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPLV, SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.