Tag Archives: time

The Upside And Downside Of Market Capture With Alternatives

By Richard Brink Over the long run, alternative investments have outpaced traditional 60/40 stock/bond portfolios with lower volatility. What’s the secret? Gaining more in up markets than they lose in down markets. The Upside/Downside Capture Ratio Successful alternative strategies are managed to capture some part of the equity market’s upside and an even smaller part of the market’s downside. The concept is to win by not losing, and it’s reflected in the up/down capture ratio. Let’s take a strategy with an up/down capture ratio of 50/20. When markets are doing well, it delivers 50% of the upside; when markets are down, it delivers 20% of the downside. Capturing only half of the equity market’s gains in an up market with an alternative strategy may not sound too appealing on the surface. But what’s the flip side? In bear markets, investors experience only 20% of the downside. Alternatives vs. Equity: The Tortoise and the Hare Let’s compare a hypothetical $10,000 investment made in 1995 – for 20 years – in the S&P 500 equity index with an equal investment in a hypothetical alternative strategy with a 50/20 up/down capture ratio (Display). It ends up looking a lot like the fable of the tortoise and the hare. The S&P 500 – the “hare” in this scenario – got off to a fast start. During the tech bubble buildup in the late 1990s and early 2000s, the equity market dominated – and the gap between the two investment approaches widened. But then the tech bubble burst, and the S&P 500 lost major ground. The 50/20 alternative strategy – the “tortoise” – which had been steadily, if modestly, plugging along at “half-speed” until the sell-off, pulled ahead. As we know, markets eventually stabilized and US equities resumed their upward march. But just as the S&P 500 started to catch back up, the 2008 financial crisis sent stocks reeling again. The S&P 500 lost 51% of its value by early 2009, while the 50/20 declined by only 10%. The importance of that is found in the time needed to recover the losses. In the recovery that followed, the 50/20 was back to its previous peak in nine months. The S&P 500 took more than three years. Indeed, despite very strong US equity market performance over the past several years, the S&P 500 has still not caught up. Over a 20-year span of this tortoise and hare battle, the alternative strategy would have ended up delivering dramatically higher returns than the S&P 500 – but with less than half of the stock market’s volatility. Pretty crafty turtle. Click to enlarge The Insurance Perspective Why doesn’t everyone find an alternative strategy with 50/20 up/down capture? After all, this isn’t just hypothetical – the average up/down capture ratio of the entire HFRI Equity Hedge category, for example, is 65/32. In large part, it likely has to do with the investment experience. In other words, some investors would rather simply fire a manager who delivered just 50% of the market’s upside in a rally. When that frustration sets in, it’s easier to dismiss a strategy’s effectiveness in bear markets. This was magnified in the past few years by a central bank-supported “beta trade,” with strong performance and generally short-lived downturns. That appears to be changing, but investors need to be diligent in searching for a strategy that fits their long-term needs. It helps to think of a strategy’s up/down capture ratio as an insurance policy. For the strategy with 50/20 up/down capture, the difference between the market’s gain and the strategy’s up capture – in this case, 50% of the full market gain – is the insurance premium you pay in terms of sacrificed upside potential during up markets. The “down” capture of 20% can be viewed as a deductible – you experience a loss of 20% on the alternative strategy before its “policy” kicks in and protects the downside. Finding the Right Fit Alternative strategies come with many different combinations of upside and downside market capture. We think the best way to approach the choice is by following three steps: 1) Find a strategy with a level of upside capture you’re comfortable with 2) Make sure there’s a complementary downside capture 3) Gain confidence that the manager can continue to deliver that experience consistently It all comes back to a point we’ve emphasized before: Investors should know what they want when they’re looking for an alternative strategy. And they should identify the right manager who can consistently deliver the return experience they’re looking for. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management team s Richard Brink, CFA – Managing Director-Alternatives and Multi-Asset

Exits: Know When To Hold ’em, Know When To Fold ’em

Originally published March 29, 2016 We all focus a lot of attention, perhaps too much attention, on where to buy and sell a market, on where to enter trades. Today, let’s spend some time looking at the other side: where are you getting out? Some categories are useful here, and they are not complicated. First, we have exiting at a loss, or at a profit. (This is not necessarily the same as saying exiting on a stop or at a profit, because a (trailing) stop can often be a profit-taking technique.) Both of these can then be divided into two more categories: Exiting at the initial loss or a reduced loss, and profit taking against a stop or at a limit. Let’s spend a few moments thinking about each of these. Initial stops The most important think about initial stops is that you have one. Though so many trading axioms and sayings do not apply universally, one that does is “know where you’re getting out before you get in.” For every trade, you should have a clearly defined maximum loss, and you should work hard to make sure that loss is never exceeded. In practice, bad things will happen. You will have the (hopefully rare) experience of a nasty gap beyond your stop, and sometimes will see losses that are whole number multiples of your initial trade risk. (I remember one lovely -4.5x loss in Yahoo (NASDAQ: YHOO ) years ago. Though these events are rare, they are also a good reminder of we do not, for instance, risk 10% of our accounts on a trade. A 45% loss on a single trade would be a disaster, but 4.5x a reasonable risk (1%-2%) is merely annoying.) Initial stop placement is an art in itself, but, in general, I think too much of the material on the internet probably uses stops that are too tight. I’ve never seen anyone trade successfully with stops that are a few ticks wide. For me, initial stops usually end up somewhere around 3-4 ATRs from the entry. These stops are wide enough that many traders find them uncomfortable, but simply reducing position size to manage the nominal loss is an obvious solution. Taking losses is perhaps the most important thing you will do as a trader, so do it well and do it properly. Click to enlarge Reduced stops We have defined that initial “never to be exceeded” (ideally) stop at trade entry, but many traders find it effective to move that stop rather quickly. Another possibility to consider is the time stop, in which we take steps to limit the position risk if the trade does not move in some defined time. There are many possibilities here, ranging from tightening the stop, to reducing the position, to exiting completely. I have made a good case for not reducing the position at a loss because it effectively “deleverages” your P&L in the “loss space.” (See the chart above, which is drawn from pages 242 and 243 of my book.) Personally, I’ve found that simply taking whole, but smaller than initial, losses is more effective, but your experience may be different. A key point here is that all of this – entry, exit, position size, moving stops, taking targets, re-entries, adding to positions, partial exits, etc. – all of this must work together. You change one piece, and the whole system will change. This is why some techniques may be effective in some settings but not in others. To simplify, think of reduced stops as being moved when the trade does not immediately go far enough in your favor, and consider the use of time stops. Profit targets Profit targets are usually limit orders, as opposed to stops (which, not surprisingly, are usually stop orders). In general, I find that it makes sense to have profit taking limit orders working in 24-hour markets, though we may not wish to work stops in the same after-hours environments. People sometimes make mistakes or do silly things in after-hours, and I’m always happy to provide liquidity at the right prices. There is a school of thought that says that all trades should simply be exited at profit targets, while there is a conflicting school that says we must let our winners run. How to reconcile these two approaches? I think the answer lies in trading style. For trend traders, we must let our profits run. As countertrend traders, we must take quick profits, usually at pre-defined areas. I have not found chart patterns or points to be any more effective than simply setting a target 1x my initial risk on the “other side” of the entry. Many people like to use pivots or trendlines, but I’ve executed well tens of thousands of trades (one of the advantages of spending years as short-term trader) and have simply not found these to be that effective. (For intraday traders, highs and lows of the day do deserve respect.) Consider the tradeoffs in simplifying your approach. Trailing stops Trailing stops can be managed in many ways, and I have found these to be very effective in many types of trading. We can trail at some volatility-adjusted measure, and there are even times we trail a very tight stop, effectively hoping to be taken out of the trade. This is a good problem to have: sometimes you may trail a stop at yesterday’s low, and be shocked as the trade grinds in your favor week after week – there’s nothing to be done in these cases but be forced to stay in the trade and make more money, but guard against hubris: many of the times this has happened to me; I have been properly positioned into a climax move. When these moves end, they often end dramatically, so simply ring the register and step away from the market. Putting it all together This is certainly not an exhaustive list of all the possible ways to exit trades, but it will get you started in the right direction. I find that combining these techniques, using a pre-defined target for part of the trade, trailing the stop on the rest, and moving quickly to reduce initial risk on my rather wide initial stops, this works very well for swing trading the markets I follow. Consistency certainly matters, but consistently doing something that works will, not surprisingly, lead to consistently losing money. Make sure you have a well-designed system with an edge, and that the system is one you can follow in actual trading. Make sure you trade with appropriate size and risk, and that you monitor your performance accordingly. With these guidelines, you can be a few steps closer to developing your own system and approach to trading.

Difference Between Value Stocks And Growth Stocks

Analysts like to separate stocks into two categories: value and growth. What is the difference between value stocks and growth stocks, and which style provides better returns? There is no exact definition explaining the difference between value stocks and growth stocks, but each has its own distinct characteristics. In general, value stocks have low price ratios and growth stocks have high price ratios. Value stocks as a whole have been shown to outperform growth stocks over time. Future Expectations The low price ratios of value stocks are a result of investors being cautious about the future of the underlying companies. Similarly, the high price ratios of growth stocks are a result of investors being excited about the future of the underlying companies. While discussing mutual fund investing using either growth or value stocks, Fidelity says the following : Growth funds focus on companies that managers believe will experience faster than average growth as measured by revenues, earnings, or cash flow. The goal of value funds is to find proverbial diamonds in the rough; that is, companies whose stock prices don’t necessarily reflect their fundamental worth. In the stock market, companies are valued based on future expectations. Wonderful vs. Weak If a company’s growth begins to slow down or its profits start to decrease, the result will be a lower share price. Value stocks are typically companies with recently poor operating results and negative outlooks. The weak performance could be due to macroeconomic events or company specific challenges. It could be a temporary setback or a major loss of market share. If a company is growing and its profits are increasing rapidly, the result will be a higher share price. Growth stocks are typically companies with recently phenomenal operating results and bright futures. The wonderful performance could be due to a rising tide in a particular industry or great management of a specific company. If growth stocks are “wonderful” and value stocks are “weak”, how can value stocks be better investments than growth stocks? Value Premium It turns out that human nature causes value stocks to provide better long-term returns than growth stocks. People get too excited about growth stocks and too afraid of value stocks. While discussing the recent trend of investors moving away from value opportunities, Morningstar’s Ben Johnson said : What we’ve seen historically is that it’s exactly this sort of capitulation, this sort of behavioral function that may actually lead to the existence, the creation, the persistence of the value premium. Value exists because there are suckers on the other side of the poker table willing to take the flipside of the value bet. They are betting on growth or something else. Real, true, strong hands at that poker table, in all likelihood will continue for many years to come, to reap the benefits of that value bet, assuming that they are strong hands. The optimism towards growth stocks makes them overvalued. The pessimism toward value stocks makes them undervalued. Investors become overly confident about a growth stock’s future and overly scared about a value stock’s future. Herd Behavior Through a phenomenon called herd behavior, human nature causes a gap to occur between the value of a stock and its price. Herd behavior says that “individuals in a group will act collectively without centralized direction.” In Thomas Howard’s book, Behavioral Portfolio Management , he talks about how following the crowd is an evolutionary trait. It was beneficial at one point but now does more harm than good, especially in investing. Howard says: Doing the same thing as everybody else, the definition of social validation, also made sense thousands of years ago when life was full of danger. Since we lived in small groups then, we depended on others to sense danger and react instinctively. You didn’t want to be the slowest member of the group when fleeing the tiger. In contrast, today we frequently want to take positions different from the emotional crowd as a way to harness the price distortions resulting from collective behavior. Because the stock market is nothing more than a group of individual investors, herd behavior is a common occurrence. No investor wants to be left behind. As prices start climbing, everyone wants to jump on board. This results in the high valuations of most growth stocks. Once prices start falling, investors dump the underperforming stocks in mass. This results in the low valuations of value stocks. It’s important to refrain from following the crowd and to avoid investing in overvalued stocks rather than undervalued stocks. The Difference Between Value Stocks and Growth Stocks A summary of the difference between value stocks and growth stocks is: Value stocks are undervalued, out-of-favor companies with recently poor operating performance and slowing growth. Investors overreact to these stocks and value them lower than they should be. Growth stocks are overvalued, “hot” companies with recently great operating performance and rapid growth. Investors overreact to these stocks and value them higher than they should be. Understanding the difference between value stocks and growth stocks will allow investors to profit greatly over time.