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Michael Dever
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Founder, CEO & Director of Research for Brandywine Asset Management and author of "Jackass Investing: Don't do it. Profit from it." I have been a professional investor/trader since 1979 and have experience in stocks, managed futures, commodities, mutual fund arbitrage, market... More
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Mike Dever
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Jackass Investing: Don't do it. Profit from it.
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  • Return Drivers, Correlation And Diversification

    In last month's report we provided a brief review of Return Drivers and how some of the new fads in the investment industry, such as smart beta (or strategic beta) as well as the well-entrenched terms alpha and beta, are simply clever (or maybe not so clever!) terms that describe the level of public awareness associated with what is actually a small sub-set of available Return Driver based investment strategies.

    As we said in that report:

    "There is nothing special about smart beta. Once we understand that every valid investment strategy (such as buying-and-holding stocks or value investing) is based on a relevant Return Driver, we realize that beta, smart beta and alpha are merely terms used to differentiate the level of public acceptance of each Return Driver. In short:

    • Beta describes strategies (such as buy-and-hold) that are based on Return Drivers that are widely exposed and accepted as being valid in the public domain.
    • Smart Beta refers to Return Drivers that have been exposed but are not yet as widely employed or accepted in the public domain.
    • Alpha is the term used to describe Return Drivers that are not yet widely disseminated or accepted in the public domain.

    It's as simple as that."

    We're repeating this explanation here because Return Drivers not only provide an elegant framework to help resolve some of the most important investment debates (such as that between "passive" and "active" investing), but understanding them is also at the heart of an investor's ability to construct a truly diversified portfolio.

    Here's an example:

    It has been common over the past year or so to hear people make the comment "with interest rates so low, stocks are the only game in town." It is easy to understand why people have this view. If their investment beliefs are constrained by the use of asset classes, alpha and beta, their resultant investment process will lack the flexibility to allow them to create a truly diversified portfolio. For example, with interest rates on 10-year U.S. government bonds at less than 2.5%, a pension plan that requires a 7% return on its capital will lose by putting their money into bonds. If they view the investment world in terms of asset classes, as legions have been taught to do since the invention of asset classes in the 1960s, they are essentially constrained to owning stocks, bonds, commodities, real estate or cash. For many funds in this predicament, holding long stock positions appears to be the only way to achieve their required return.

    The investment world is completely different for the Return Driver based investor however. They see that owning stocks is just a simple investment strategy based on one combination of a valid Return Driver (rising corporate earnings) coupled with a relevant market (common stock). They see that there are dozens, if not hundreds, of other relevant Return Drivers that can be developed into strategies to profit from the movement of dozens (or hundreds) of other markets.

    One such approach that has started to become popular is that provided by trend following CTAs. They exploit a proven Return Driver (market momentum) to capture profits over time from price movements in a wide range of global markets. This strategy is no less valid or relevant than buying stocks based on the expectation of earnings growth. This is an important-perhaps the most important-statement. Just because an investment strategy is more or less accepted by the financial world, doesn't mean it is more or less valid. The validity of an investment strategy is based on the validity of its underlying Return Driver, not the popularity of its use.

    But buying stocks and trend following in global markets are just two out of the many investment strategies that can be employed to create a diversified portfolio. And despite the preponderance of long stock positions held in most people's portfolios, one is no less important than the other. But these two approaches (along with the other long-only strategies defined by the other "asset classes") are not the only games in town. Once an investor accepts the validity of owning stocks in anticipation of rising earnings, or selling crude oil based on the strong downside momentum in its price, the opportunity exists to create a truly diversified portfolio by developing - or investing with managers that have developed - other investment strategies based on other, equally valid, Return Drivers.

    Brandywine has developed and employs dozens of investment strategies based on dozens of disparate Return Drivers. Because of this, as we showed in last month's report, there is no correlation between the returns produced by Brandywine and those of virtually any other investment index. An additional benefit is that we are not limited to what appears to others to be "the only game in town." There are always numerous other games to play.

    While we won't reveal the specifics of each of the investment strategies we employ, as it would be a disservice to our investors, who benefit from us keeping them out of the public domain, we continue to be very open with providing some examples of the Return Drivers we exploit. If you are a serious investor and would like to discuss this with us, please feel free to contact Rob Proctor or Joe Gabor and we will schedule a presentation.

    Jun 09 1:44 PM | Link | Comment!
  • Taking Alpha & Beta To The Junkyard

    The Virtues of Return Driver based Investing

    In 1934, Benjamin Graham and David Dodd introduced the world to value investing when they published their seminal book Security Analysis. In 1948, Richard Donchian introduced the world to momentum trading after he launched the first public futures fund and applied "trend following" (momentum trading) to a diversified portfolio of futures markets.

    Both value and momentum are valid "Return Drivers." Warren Buffett made billions by following value principals to select stocks. John W. Henry earned billions (which he parlayed into a sports empire that includes the Boston Red Sox) by employing momentum strategies to trade futures contracts on global financial and commodity markets. Significant profits were also produced by other investors who employed these Return Drivers in the decades following their introduction.

    For the first half century after they were "exposed," the excess return which traders earned by employing strategies based on these Return Drivers was considered "alpha." This was in contrast to the returns that could be obtained simply by buying-and-holding the "market," which has been called "beta."

    Slowly, however, others began to take notice. In1992, Eugene Fama and Kenneth French published "The Cross-Section of Expected Stock Returns" in The Journal of Finance. In the paper they bestowed an academic imprimatur on value investing. In later papers they and others presented research that revealed the effectiveness of momentum investing. Over time, the profit earned from employing strategies based on these Return Drivers was no longer considered alpha. But they didn't yet fit into the classic definition of "beta." A new term was required. Enter "Smart Beta" or "Strategic Beta."

    This leads to the question, "What is Beta, Smart Beta and Alpha?"

    The answer starts with understanding Return Drivers.

    What is a Return Driver?

    A Return Driver is the primary underlying condition that drives the price of a market. When it is defined in this fashion, we realize that buying-and-holding stocks isn't beta. It is simply another Return Driver based investment strategy - the Return Driver being the fact that over the longer-term (periods of 20 years or more) an increase in corporate earnings leads to an increase in stock prices. If you believe there should be an increase in earnings, buy stocks. Value investing is simply the acknowledgment that over the long term, competition results in a leveling of profit margins among similar companies, so all else being equal, buying the "cheaper" stock today will produce greater returns than buying the "expensive" stock.

    Once Fama and French uncovered value (and also the small cap effect) as being valid Return Drivers (they and other academics refer to them as "Risk Factors" under the misguided belief that returns are earned in exchange for assuming risk, which is seldom the case), the floodgates began to open for equity investors.

    Over the past decade or so, academics have "discovered" numerous Return Drivers, including those based on dividends, volatility, illiquidity, and cash flow; and fund marketers have launched hundreds of smart beta mutual funds and ETFs designed to capture profits (for themselves at least!) by exploiting these Return Drivers.

    But there is nothing special about smart beta. And once we understand that every valid investment strategy (such as buying-and-holding stocks or value investing) is based on a relevant Return Driver, we realize that beta, smart beta and alpha are merely terms used to differentiate the level of public acceptance of each Return Driver. In short:

    • Beta describes strategies (such as buy-and-hold) that are based on Return Drivers that are widely exposed and accepted as being valid in the public domain.
    • Smart Beta refers to Return Drivers that have been exposed but are not yet as widely employed or accepted in the public domain.
    • Alpha is the term used to describe Return Drivers that are not yet widely disseminated or accepted in the public domain.

    It's as simple as that.

    How this Relates to Brandywine

    Brandywine employs a diversified Return Driver based approach to invest across more than 100 global financial and commodity markets. The vast majority of our strategies are based on Return Drivers that are not widely disseminated or accepted in the public domain and therefore are considered "alpha." That said, we are agnostic as to how others may classify our strategies, whether alpha, beta or other. Our only interest is to achieve the most consistent and predictable returns possible over the long-term. We do this by creating a portfolio balanced across Return Drivers and markets. Interestingly, this single-minded focus to employ the best and most diverse Return Drivers results in performance that is also completely uncorrelated with that of all major investment indexes and other investment managers. This is illustrated in the chart below:

    Despite our unique approach and resultant non-correlation however, Brandywine's Symphony Program is often confused with trend following CTAs. This is because, similar to them, Brandywine is registered with the Commodity Futures Trading Commission and is a CTA member of the National Futures Association. And since the majority of money being managed by CTAs is invested pursuant to trend following strategies, Brandywine is often, incorrectly, considered to be a trend follower

    But as is made clear by the preceding correlation chart, our registration does not define our method. With a zero correlation, Brandywine is clearly doing something different. But does different mean better? We think so. Despite currently being in the midst of our largest drawdown to date (which troughed at -13.94%), and the CTA indexes hitting new highs (on the back of strong trends in currency, interest rate and energy markets), Brandywine has still outperformed the CTA indexes since the inception of Brandywine's Symphony Program in 2011. But not only does our Return Driver based approach make us different, it also underlies the reasons why Brandywine is well-positioned to serve as the core investment in any investment portfolio:

    Brandywine has the necessary traits that are required to be a "core" investment:

    • Brandywine's Symphony Program is highly diversified. With a single investment Brandywine provides investors with coverage across more than 100 global financial and commodity markets. Equity portfolios lack the diversity of Return Drivers, and specialized CTAs lack the strategy or market diversification required to serve as a true "core" holding.
    • Brandywine employs a systematic process that solves for performance predictability. Other investment programs that rely on the daily decisions of a key person or team are subject to model variability, as day-to-day trading activity is subject to the feel of the portfolio manager(s).
    • Brandywine's performance is uncorrelated to every other investment. With Brandywine at the core, virtually any other investment can be added to a portfolio and it will provide diversification value. This is not the case if a long-only equity manager or other diversified CTA (such as a trend follower) is placed in the core position.
    • Brandywine's Symphony Program provides liquidity and transparency.

    In Summary…

    Beta is a term that was developed to describe stock market returns. Rather than uncovering the true underlying Return Drivers, academic explanations such as the equity risk premium were developed to explain rising stock prices. While this puts a name on observed market behavior, it does nothing to enable an investor to create trading strategies based on exploitable Return Drivers.

    Return Driver based investing requires explanations. This not only leads to a truer understanding of the source of returns, but also opens up the opportunity to uncover additional Return Drivers that can serve as the basis for multiple investment strategies, each relevant to a particular market. Value, momentum, illiquidity and the small cap effect are just some of the many, many Return Drivers available. But once it is understood that they are Return Drivers, and not magical alpha, or smart beta, the framework exists to develop additional investment strategies, based on other unique Return Drivers, and create truly diversified portfolios capable of producing positive returns across a wide range of conditions.

    May 06 12:57 PM | Link | Comment!
  • Controlling Your Destiny

    In a recent television interview, the head of the asset management arm of one of the world's largest private banks remarked that her number one concern was what the Fed would be doing. She is not alone; numerous other investment managers have expressed the significance of Fed decisions on the performance of their portfolios. Many believe the bond and stock markets are artificially priced (read "higher") today as a result of the Fed's actions or anticipated actions. Even Mohamed El-Erian, who rode the bond bull market to fortune and fame while at PIMCO, has stated that the majority of his money is now in cash, as he thinks most asset prices have been pushed by central banks to very elevated levels. He admits this means his portfolio value runs the risk of being diminished due to inflation, but prefers the inflation risk over the risk of having a Fed decision damage his portfolio.

    Concern over Fed action (or inaction) is not the problem. It is merely the symptom of a much larger and pervasive problem. Because their portfolios are dominated by long stock and bond positions, these people have subrogated their investment responsibilities to a handful of people at the Fed (if not just one person!). Literally trillions of dollars of other people's money is essentially out of their control. Not only is this ridiculous, but it is also unnecessary.

    Long positions in stocks and bonds are only two potential ways to make money. In fact, to rely on portfolios dominated by long stock and bond positions is not investing at all. It is gambling (defined in this instance as a person taking unnecessary risks with their/your money), especially when the performance of those long stock and bond "poor-folios" is under the influence of a single decision maker, the Fed. But even without that dependency, it is a gamble to rely on the continued advance of stocks and bonds to produce positive returns. And it is unnecessary because there are so many additional opportunities available for people to truly diversify their portfolios.

    "True" Portfolio Diversification

    Portfolio diversification is the one "Free Lunch" of investing. It enables a portfolio to target both higher returns and less risk than a less-diversified portfolio. But while portfolio diversification is often preached, it is seldom practiced. That is because of the misguided focus on spreading money across long positions in "assets" or "asset classes." By their very definition, asset classes are comprised of a group of securities that exhibit similar characteristics and perform similarly. So, very little diversification value can be obtained by spreading money across assets within each asset class. And if a "poor-folio" is constrained to only holding long positions in asset classes, and if those asset classes are subject to the same event risk (such as a Fed decision), then spreading money across asset classes provides little diversification value. Fortunately, there is an alternative.

    Return Driver Based Investing

    A Return Driver is the primary underlying condition the drives the price of a market. Today, both stock and bond markets are dominated by Fed action. That is the single dominant Return Driver. But rather than subject your portfolio to a single Return Driver, which results in singular event risk, you can diversify across numerous other Return Drivers. Not only will this diversify risk, but it will also create a portfolio that behaves independent of stocks and bonds. This is the approach taken by Brandywine. In addition to dramatically reducing the risk that an adverse Fed decision (or any single event) would have on the portfolio, this approach also results in performance that is completely uncorrelated to the performance of all other investment indexes, including stocks and bonds.

    The results speak for themselves. Since the inception of Brandywine's Symphony Program in 2011, the correlation of monthly returns between Brandywine and the S&P 500 has been just 0.19 and between Brandywine and bonds (measured by the Barclay Aggregate Bond Index) just 0.27. As a result, adding Brandywine to a "conventional" 60-40 portfolio both increases returns and reduces risk, as shown in the following table:

    (click to enlarge)

    Bottom line: if you have a portfolio that is long stocks and/or bonds, or other Fed-dominated assets, and are concerned with how a drop in asset values will negatively affect your portfolio, adding an investment in Brandywine will create important diversification value.

    Apr 08 10:41 AM | Link | Comment!
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