Tag Archives: portfolio-strategy

The One Factor To Explain Them All

Yesterday’s post on hedge funds got me thinking again about how vague “risk factors” are. CAPM uses a one factor model showing that risk explained why certain assets performed better than others.¹ Basically, take more risk and you’ll generate a better return. That didn’t exactly explain things fully though. In fact, higher risk often correlates with worse returns.² Over the course of the last 25 years the idea of “factor investing” has really boomed. And investment companies loved this because they could market specific stylized facts that explained why the markets do certain things and why you should pay them high fees so they can take advantage of those things for you. Heck, even hardcore passive investors, who are notorious fee avoiders, will trip over themselves buying higher fee funds trying to guess the best factors to own at certain times. As a result, we got the small cap factor and the value factor and the momentum factor and all sorts of other factors. I think we’re up to 1,000+ factors now. There are so many I could just start making them up. And I will. Right now. For instance, companies whose founders are dog owners might outperform companies whose founders are cat owners. This is a perfectly logical assumption because dogs are better than cats so company founders who own dogs must be smarter than company founders who own cats. So, we now have the dog vs cat factor. If I tweak some data and find it’s statistically meaningful over long periods of time then I might even start a high fee fund to sell you. No cat owners allowed, obviously. Okay, okay. I am being stupid. I know. But you see my point, right? A lot of these “factors” could be nothing more than slick data mining by someone who found a pattern that doesn’t really exist. We want to understand and be able to predict things so badly that we often find stylized facts where they don’t even exist. But maybe we just can’t know. That doesn’t mean it’s not worth trying to find out or to try guessing about future outcomes. But we should start from one general factor: The We-Know-A-Lot-Less-Than-We-Think-We-Know Factor This doesn’t require some law of the financial markets that says anything has to outperform anything else over the long-term. Yes, we know that stocks will generally beat bonds because they’re a contract that gives the equity owner greater claim to profits than the bonds, but that doesn’t mean stocks have to outperform bonds or even that they’re more risky (whatever “risk” means in the context of this discussion to begin with, but that’s a whole other matter). The point is, you don’t necessarily earn a “risk premia” in stocks. You earn a contractual premia assuming the firm earns enough profit to pay it out (good luck predicting which firms will generate the highest profits in the future) and a bunch of apes with keyboards try to guess what the future value of those profits will be. Importantly, no one needs the efficient market hypothesis to understand why markets are really hard to beat. You just need the basic arithmetic of global asset allocation to understand that . This whole monetary system is something humans created from thin air. And we have, at best, an imprecise understanding of what financial assets are really worth at certain times and so the best we can do is try to understand the world for what it is, slap together some sound assumptions about the future, reduce our frictions, manage the known risks as best as possible and hope it doesn’t all fall apart at some point. Is it really much more complex than that? ¹ – Here’s the Three Factor Model. Here’s the Five Factor Model. Here’s a 100+ Factor model paper. Here’s a real model. 2 – See this paper titled ” High idiosyncratic volatility and low returns: International and further U.S. evidence “.

A Dim Light Shines Out Of The Deep Value Investing Cave

One tea leaf indicator that is used to get a sense of the future direction of the overall stock market is the number of stocks moving down in price. More stocks are now trading below their 200-day moving average than above it. Some investors might view this negatively, but an increasing number of stocks falling in price is a telling sign that brighter days lie ahead for deep value investors. Falling stock prices are a necessary but insufficient condition for deep value stocks to bubble up to the surface. This may seem counter-intuitive to investors who desire an ever-rising stock market, but for value investors, the opportunity to find true bargains increases following a significant market decline. One of Benjamin Graham’s more aggressive value investing strategies was to purchase stocks trading below their net current asset value . If a stock was beaten down in price so far to where it traded below what a private owner would value it upon liquidation, investors could take advantage of the anomaly and scoop up the bargain. Holding a deep value stock until the market price exceeds its net current asset value has historically produced excellent returns over the long term. An ever greater number of stocks trending below their long-term moving average is consistent with a future environment conducive to deep value investing. Some percentage of stocks trading below their moving average will eventually reach a valuation level consistent with Graham’s original concept of a true bargain. The chart below shows the percentage of net current asset value stocks that experienced a significant price decline before making their way into a deep value portfolio. (click to enlarge) Source: V. Wendl, The Net Current Asset Value Approach To Stock Investing , (2013): p. 184 . As indicated in the chart, nearly 80% of all stocks lost money over the previous five-year period before entering the net current asset value portfolio. This holds true in both bull and bear market years over the 50-year-plus study period. As more stocks join the growing herd trading below their 200-day moving average, a certain percentage of them will fall to such an irrationally low price point that deep value investors might take an interest in them. Waiting for stocks to reach a true bargain basement price level requires patience. It is a process that unfolds gradually over time. If most stocks are in a general decline , as they are currently, the evidence shows that some will continue to fall in price to a price point below net current asset value. The chart below shows the performance of a typical net current asset value stock over the five -year period of 1955-2008 before it entered the deep value portfolio. The chart is restricted to rolling five-year time periods when the overall stock market was in decline. There existed 10 overlapping five-year periods over the past 50-plus years when the stock market dropped in value. (click to enlarge) As indicated in the chart, more than half of the stocks declined in price by more than 60% before entering the net current asset value portfolio. Over a typical five-year losing period in stocks, the ones trading below liquidation value experience close to seven times the price drop in comparison with the overall market. This unfolds over years, not months. Mr. Market is at times tenacious, forcing deep value investors to wait a long time before labeling certain stocks a true bargain. Remaining on the lookout for a crack of light peering through the financial engineering monstrosity blocking our view of true bargains is the hallmark of a true disciple of Graham’s teachings. Share this article with a colleague

Response To: Structured Note Read The Fine Print

Response to a biased article by AllianceBernstein on Structured Notes. Structured Notes may be helpful in introducing, reducing or modifying risk. The referenced Structured Note is not given credit in the referenced article for the downside protection it provides. Furthermore, to compare to a balanced portfolio which wins in all markets is unrealistic. I recently came upon a Seeking Alpha article by Alliance Bernstein titled Structured Notes: Read the Fine Print . The article expressed a fairly negative and, in my opinion, inaccurate view of structured investing based on an analysis of one structured note in particular. As an experienced structurer and trader prior to founding Exceed Investments, I’d like to help set the record straight. The article analyzes a 5-year 28% buffered note on the S&P 500 as an example. While they do not share a link to the terms, the note is similar to, if not exactly the same, as this note . First, let’s briefly consider what a structured note is and discuss its purpose. Structured notes are an example of what I call “defined outcome” investments, which are options-based strategies that allow investors to shape a risk/ reward exposure to fit their personal objectives. In these strategies, market participation levels are preset. Therefore, the targeted downside participation is known in advance, as is the upside potential. A defined outcome investment can be built to introduce risk, reduce risk, or modify it – in this case, the 28% buffered note offers S&P exposure with a material level of downside protection, which I will refer to as downside “insurance” in this article. Performance at maturity, assuming no default of the issuer, looks like this (X axis is Adjusted S&P 500 return; Y axis is the Note return): An investor may be interested in this product if they are risk-averse but still want to participate in equity markets (e.g., an executive who is retiring in 5 years from now and can’t take a big hit over the next 5 years). The “insurance policy” of this note will cover up to 28% of downside “damage” 5 years from now – e.g., market down 28%, investor loses 0, market down 40%, investor loses 12%. As in all insurance policies, a premium needs to be paid – in this case, the investor loses all dividends of the S&P 500. Over 5 years, those lost dividends amount to about 12% in a reasonable model scenario (2% annual dividend rate, assumed reinvestment at a compounded 8%). Is 28% of potential downside insurance worth giving up 12% of dividend upside, while still participating in the price appreciation of the S&P 500? There’s no right answer to that question as it depends on an individual’s needs and perspectives. As mentioned, I found a number of inaccuracies and misrepresentations (e.g., expense levels, liquidity) in the article but will focus on the main items which I found to be flawed. To summarize: The article directly compares the expected performance of the S&P 500 with the Note, without fairly pointing out the insurance benefit provided by the Note The article then compares the performance of a balanced portfolio with the Note, which I find two issues with – Why compare a product vs. a balanced portfolio? It’s an unfair comparison – no sane investor would invest all their funds in a single note The balanced portfolio described is somehow expected to gain during equity declines as well as fairly closely match bull returns, which is just impossible Greater detail follows: “Our analysis suggests that this structured note has an 80% chance of underperforming the S&P 500 over the next five years…” On one hand, while I can’t attest to the accuracy of their model, it seems reasonable. The note will underperform the S&P if the S&P finishes > -12% after 5 years. That’s because the cost of the insurance purchased, (i.e., 12% of lost dividends), will be greater than the insurance “payout” if the market isn’t down by more than 12%. Given historical performance, odds are the S&P does better than a cumulative -12% over the next 5 years. On the other hand, this isn’t a fair statement. If an investor buys any type of insurance, (e.g., earthquake insurance, fire insurance, theft insurance) and there is no major catastrophe in the next 5 years, which is usually the case, the investor will lag the performance of people who didn’t buy insurance. The same is true of buying 28% worth of portfolio insurance – if the market isn’t down by at least your premium spent, you will lag. That obviously doesn’t mean ipso facto that no one should buy insurance. “Projecting thousands of plausible outcomes across all types of market environments, we found that the median outcome for the structured note is more than 6% below what we’d expect from a fully diversified balanced portfolio, as the next Display ” For starters, no reasonable investor would take all their assets and purchase this single structured note vs. choosing a balanced portfolio. A more reasonable approach to this comparison may be to replace a relevant component of the balanced portfolio, for instance large cap value, with the structured note and then stress test outcomes between the two varying portfolios. Now let’s talk about the finding that a balanced portfolio over 5 years results in a median 4.5% return when the stock market finishes down, and a median 38% return when the market finishes up (which is apparently just about equal to the S&P price return). While I am sure their model is well designed, this simply doesn’t pass the smell test. How did individuals with balanced portfolios do in 2008? Hint: not very well. I am not aware of any product or portfolio design that had positive returns in 2008 and then proceeded to equal the price return of the S&P 500 over the following five years. If someone else is, please share it with me so I can invest. In conclusion, while I acknowledge that Structured Notes have issues (I cover them in detail at the end of this white paper ), which is what drove me to found Exceed Investments in the first place, this article does not treat them fairly. Ultimately, the referenced note provides a very defined risk / reward exposure to the S&P 500, providing a level of downside protection that may be deemed appropriate and/or may resonate for a subset of investors. 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. I have no business relationship with any company whose stock is mentioned in this article.