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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
My company:
Brandywine Asset Management
My blog:
Mike Dever
My book:
Jackass Investing: Don't do it. Profit from it.
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  • The Constraint Of Asset Classes

    Since the 1960s, asset classes have dominated the investment landscape. Originally "invented" out of necessity, they evolved to serve as the foundation of conventional portfolio diversification. They got their start shortly after Harry Markowitz published his seminal paper "Portfolio Selection." This paper eventually led to the popular adoption of mean-variance modeling to create "optimally" diversified investment portfolios. But in order to determine an optimal stock portfolio, the Markowitz model required a person to calculate the covariance of every stock in a portfolio in relation to all others. Because computer technology was in its infancy and the "cost" (not just in computer resources but in actual dollars and cents as well) to do this was exorbitant, a simpler method needed to be devised. Enter Bill Sharpe, who developed a simplified system that instead compared each stock to the market as a whole. The "market as a whole" became an asset class. Initially, there were just a few asset classes, such as stocks, bonds and cash.

    Over the years, investment professionals have established increasingly varied asset classes (and sub-asset class "categories"). For example, many now consider real estate and commodities to be asset classes. And emerging market stocks and high-yield bonds may still be considered to be part of the stock and bond asset classes, but they are also understood to behave differently and are therefore considered to be sub-categories of their asset classes.

    All this would be just an interesting (to some) academic discussion if it weren't for the fact that trillions of dollars in investment decisions are based on allocating capital across asset classes. This makes asset classes an important and integral part of investing. And that is a problem, because the use of asset classes imposes an unnecessary constraint on a person's ability to create a truly diversified portfolio. But before we explain why, we'd like to introduce the concept of return drivers.

    From Asset Classes to Return Drivers

    One of the innovations supporting Brandywine's investment philosophy is our use of return drivers. As Mike Dever states in his book, "a return driver is the primary underlying condition that drives the price of a market" and "every return driver has a time period (and markets) over which it is relevant." Realizing that the best way to explain the return driver concept is by example, in the opening chapter of his book Mike displays the result of research that shows the relative influence of the two primary return drivers that power stock prices (which are people's sentiment towards stocks and the growth of corporate earnings). You can read a complimentary copy of the book's Introduction and first chapter here:

    Once those return drivers have been identified, they can be exploited to serve as the basis for trading strategies. Mike demonstrates this in the book's Action Section, where he shows how to develop a specific trading strategy that uses ETF money flows to exploit short-term sentiment in stock indexes and bond markets. This is an actual trading strategy being used by Brandywine today.

    The basic nature and elegance of return drivers becomes apparent when you realize that all an asset class is, is a specifically constrained trading strategy employed against a group of related markets. For example, corporate earnings growth is the dominant return driver of U.S. equity prices over periods of 30 years or more. So the U.S. equity "asset class" is simply the application of a trading strategy (holding naive long positions), applied to U.S. equities, designed to capture that return driver.

    But there are potentially dozens of sound, logical return drivers (as equally sound as earnings growth driving long term stock prices) that can be exploited to profit from trading in the U.S. equity markets. And there are potentially hundreds of additional return drivers that can be exploited to profit from trading in the hundreds of other freely-traded global financial and commodity markets. To ignore those and exploit just one creates a logical inconsistency. The stated desire of most institutional investors and their consultants (as well as most individual investors) is to create a diversified investment portfolio. But their dependence on asset classes immediately constrains their ability to do so.

    One way to attempt to fix this is to expand the universe of asset classes. In the past few years, firms such as Goldman Sachs have suggested that volatility be considered an asset class. We understand their desire to do this. Volatility trading in equities is based on a sound, logical return driver that produces returns that are uncorrelated to equities. It provides tremendous portfolio diversification. But pigeonholing volatility into the asset class construct is awkward and cosmetic. It's not a true fix.

    Brandywine's Use of Return Drivers

    Return driver based investing provides that true fix. Once you recognize that every asset class is powered by return drivers, and is therefore simply a subset of a single trading strategy, it actually becomes illogical to pursue an asset class approach instead of a diversified return driver based approach to investing. That is why return drivers are one of the key concepts underpinning Brandywine's investment philosophy and an integral contributor to our performance. In contrast, there is an inherent and sizable disadvantage to being asset class constrained.

    We pointed this out in our February 2013 report, where we stated that because of the dependence of the S&P 500 on two primary return drivers and Brandywine's broad diversification across return drivers that "over time, the S&P 500 TR index will be unable to compete on a risk-adjusted basis with the returns earned by Brandywine." This continues to be our belief today.


    The myth that portfolio diversification can be achieved by allocating money across asset classes is exposed in Chapter 17 of Mr. Dever's book. You can read a complimentary copy of that chapter here:

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Sep 26 4:12 PM | Link | Comment!
  • Gambling Vs. Investing And The Stock Fixation

    Gambling vs. Investing

    In a conference presentation given by Mike Dever to a group of retail investors last year, 10% of the audience walked out before he even got to his first slide.

    Mike started his talk by asking how many people in the audience were investors. Virtually everyone raised their hand. He then asked them if their portfolios made money when the market went up, and lost when the market went down. Again, virtually everyone in the audience raised their hand. His next statement was intended to get their attention. He told the audience that contrary to what they thought, they actually were NOT investors. They were gamblers. Following that, 10% of the audience, insulted, got up and left. His point was that if any single market dominates your performance, you're gambling.

    He followed this by explaining to the remaining people that he never told them which "market" he was referring to, yet they all assumed it was the stock market. This underscores the level of fixation people have on owning stocks. No other markets enter their thoughts, when in reality there are literally hundreds of other, equally valid markets across which they can profitably diversify their portfolios.

    The Stock Fixation

    In several prior reports(1), we discussed the fixation people have on stocks and how they intentionally hold over-weighted long equity positions. In fact, it is often touted that the model diversified portfolio is one that is comprised of 60% long stocks and 40% long bonds. But as Mike Dever states in "Myth #8: Trading is Gambling - Investing is Safer" of his best-seller, "A person who is 60% long stocks and 40% long bonds is taking unnecessary risk. They are gambling." That is because they are unnecessarily dependent on just three dominant return drivers - investor sentiment and earnings growth that power stock prices(2), and interest rate levels that power bond prices. If those falter, so does their portfolio. That doesn't even come close to defining "diversification."

    True portfolio diversification can only be achieved by diversifying across return drivers and markets. Because stock prices are powered by only two principal return drivers, a portfolio that is dominated by long stock positions will never be diversified. As a result, you will get performance that looks like this:

    (click to enlarge)

    Graph 1

    Don't get seduced by the fact that this graph ends on a high note and many stocks are now at all-time highs. People who concentrate their money in stocks have exposed themselves to unnecessary risk. The risk is unnecessary because it is easily diversified away. While academics and conventional financial wisdom tout the benefit of diversifying across additional "asset classes" such as bonds, gold and real estate, this displays a lack of understanding of the return drivers that drive the prices of each of those markets. Owning bonds at 3% is not the same as owning bonds at 10%. Return driver based investing adjusts for that fact.

    To illustrate this point, let's add a second return driver to the portfolio, in the form of a fundamentally-based strategy trading in commodity markets. When combined with the long-only S&P 500 strategy, not only is performance improved, but risk is also dramatically reduced.

    (click to enlarge)

    Graph 2

    The smoother blue line (the two-strategy portfolio) is clearly more desirable than the erratic red line (the S&P 500 Total Return index). The concept of portfolio diversification is really as simply as what we've just shown. But it doesn't stop there.

    The fact is there are potentially hundreds of return drivers that can be employed to truly diversify a portfolio. This diversified return driver based approach is at the heart of Brandywine's Symphony Program, which employs dozens of trading strategies - based on a diversity of return drivers - to trade across more than 100 global financial and commodity markets. The result is a portfolio that targets returns in excess of those that can be earned from stocks, but with substantially less risk. This is not just theoretical. You can see the actual results now.

    A Comparison: Brandywine vs. Stocks

    U.S. equities have had a great run over the recent past. Since the launch of Brandywine's Symphony Preferred in July 2011, the S&P 500 has gained 56%. But as shown in the first graph in this report, this return, because it was dependent on two dominant return drivers, subjected its participants to high levels of event risk.

    In contrast, Brandywine's Symphony Preferred gained almost 100% over the same period. And because its returns were produced from the interaction of dozens of disparate return drivers applied across more than 100 global financial and commodity markets, Symphony Preferred's event risk is much lower. In other words, poor performance for stocks does not mean Brandywine's performance will suffer as well. In fact, some of Brandywine's best performance has come during some of the worst-performing periods for stocks, as is illustrated in the following chart. This shows how Brandywine produced substantial profits at exactly the worst period for stocks over the past five years.

    (click to enlarge)

    Graph 3

    And Brandywine hasn't just provided "tail risk" protection. Brandywine outperformed stocks over the entire period as well.

    (click to enlarge)

    Graph 4

    If it really is that simple, then why do so many people; individuals, professional investors, financial gurus, public pension plans - the list includes virtually every 'investor' - gamble their money in risky, stock-centric portfolios? The answers are numerous, and one of the best compilations of well-researched reasons can be found in Daniel Kahneman's excellent book, Thinking Fast and Slow. But the very fact that people behave in irrational ways (we measure rationality as desiring to earn the most money with the least risk) is what allows so many under-exploited return drivers to exist and to be developed into profitable, and diversifying, trading strategies. That said, there are a few answers that stand out:

    1. All their friends are doing it. This is a cute way of saying that people define investment risk less by actual investment results and more by how different their results are compared to the "market." In other words, reputational risk, or career risk, dominates true portfolio risk.

    2. They, themselves, are unable to uncover return drivers, other than those currently in the public domain (which are referred to as "beta," or for those less well-known, "alternative beta").

    3. They fear missing out on the returns they can get from holding stocks. It's been banged into their heads that stocks outperform in the long-run and the best way to earn high returns is by putting money into stocks.

    We can't help with reason #1. If someone is truly more concerned with "fitting in" than making money, their affliction is outside of our domain expertise. But we can help with reasons #2 & #3. Over our 30+ years of investment research and trading, Brandywine has developed dozens of trading strategies based on numerous return drivers. These return drivers are generally obscure and not in the public domain. For example, where there might be thousands of academic papers and articles written about the long-term "risk premia" earned from buying-and-holding stocks, there is very little written about the return driver underlying the commodity markets strategy that produced the smoothed results in Graph 2. This is despite the fact that the commodity strategy is potentially even more soundly based. (We allude to the triviality of the "risk premia" construct is this past report ).

    When Radical is Rational

    So what is a reasonable allocation to be made to long equity positions in a portfolio? For those who have bought into the conventional portfolio diversification advice, the correct answer - although quite logical - can appear radical and shocking. Let's assume you are able to diversify your portfolio across 50 return drivers and 100+ markets. Everything else being equal, the allocation to a buy-and-hold strategy in stocks would approximate 1/50 of your portfolio allocation, or 2%.

    The fact that this allocation appears radical to most people is due to "reference" bias, not logic. If 60% is the reference point for an allocation to buying-and-holding stocks, any dramatic deviation from that level is "radical." In addition, because people are battered with stories of how equities produce a positive return over time, they are blinded to both the existence of - and equal profit opportunities offered by - other return drivers. As a result, they are never presented (except in limited distribution reports such as this one) with research showing the true source of the returns driving markets. Without this understanding, they are constrained to gambling on a distinctly inferior, stock market dominated "Poor-folio."

    Your Move…

    There is clearly a better way. When the next stock market decline occurs, wouldn't you prefer to be invested in a program that has the ability to not only weather the storm, but, as demonstrated by the actual performance of Brandywine's Symphony Preferred in Q3 2011, profit from it as well? We're guessing that would be interesting. And if you could have that potential protection without giving up the ability to perform well during equity bull markets, would that increase your interest? Brandywine's Symphony Preferred did just that. This report gave you a glimpse as to how and why.

    If you're intrigued and would like to learn more, please contact Rob Proctor, one of Brandywine's principals, to have him take you through our online presentation. We look forward to helping you earn greater returns with less risk.


    (1) Past monthly reports that discussed the conventional bias towards holding long stock positions:

    (2) The two dominant return drivers powering stock prices are revealed in the opening chapter of Mr. Dever's book, which you can read here:

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Aug 07 3:54 PM | Link | Comment!
  • The Stark Difference Between Mean-Variance Optimization And Brandywine's “Predictive Diversification”

    Originally published in the Brandywine Asset Management Monthly Report.


    Brandywine just completed our third full year of trading Brandywine's Symphony Program. Prior to launching the Program in July 2011 we presented our performance expectations. It was our belief that our Return Driver based investment approach and Predictive Diversification portfolio allocation model would enable us to achieve those results with a reasonable level of confidence.

    We are pleased to report that our performance has continued to track our expectations. Over the past three years Brandywine's conservative Symphony Program has achieved a +7.31% annualized return with a Sharpe Ratio of 1.03 and our more aggressive Brandywine Symphony Preferred has produced a +28.26% annualized return with a Sharpe Ratio of 1.03. Each of these performances ranks Brandywine among the top investment managers on either a risk-adjusted or absolute return basis. But more importantly, these performances track right in line with expectations.

    While every investment manager is required to disclose that PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS, Brandywine has devoted decades to understanding the aspects of investing that contribute to predictive performance. After all, if the past provides NO indication of future performance, then investing is not "investing" at all. It is gambling. In contrast to Brandywine; most academic research, and even many investment managers, focus on creating optimal portfolios - not predictive portfolios. There is an enormous philosophical and practical difference.

    The stark difference between mean-variance optimization and Brandywine's "Predictive Diversification"

    Brandywine's Symphony Program is the result of Brandywine's 30+ years of investment research and trading. When Brandywine began the development of our Brandywine Benchmark program in the late 1980s, we recruited some top academics and finance practitioners to assist us in developing the portfolio allocation model. That model would manage how much capital to commit to each individual trading strategy and market in our portfolio.

    In one test, we provided one academic researcher with performance data from more than ten strategies trading across dozens of markets. He returned with the allocation we were to make to each strategy/market combination. In short, a few strategy/market combinations were recommended to receive large allocations, while most were to receive no allocation at all. When we expressed our concern to the researcher that this concentrated portfolio was unlikely to perform well in the future (it didn't pass the "sanity" check), his response was that what he provided to us was the "perfect" answer.

    What we came to realize was that it was the perfect answer - but to the wrong question. The question the academics and our researchers had been answering was "how do I create the optimal portfolio?" - meaning one that displayed the best risk-adjusted returns on that past data. In contrast, the correct question should have been, "How do I create the most "predictable" portfolio?" - one where future performance will most closely match past performance (either tested or actual). After all, if you have low confidence that the results will repeat, then they are not really useful results at all - even if they are "optimal." His answer was perfect ONLY if future data, i.e. future market fluctuations, were similar to past data - which of course we know is not going to be the case.

    Surprisingly, there is very little (almost no) research on methods for producing the most predictable performance. Instead, decades of research have been wasted on answering the wrong question. Nobel Prizes have been awarded for it. Not surprisingly, people (and academics are people) will devote their efforts to answering the questions for which they receive the greatest reward. And for academics, the Nobel Prize is often perceived as the ultimate reward.

    Not so with Brandywine. Our interest is in producing the best possible returns for our clients and us. The realization 25 years ago that we and others were asking the wrong question led to a significant amount of new research that resulted in Brandywine's "Predictive Diversification" portfolio allocation model.

    This model has withstood the test of time. First with the performance of our Brandywine Benchmark Program in the 1990s and continuing today with the performance of Brandywine's Symphony Program. This model is predicated on the belief that the future will NOT be identical to the past. By solving for predictability, rather than optimizing on past returns, the model is better able to handle the natural changes in market conditions that are detrimental to optimized portfolios. The combination of our Return Driver based investment approach and Predictive Diversification portfolio allocation model is the reason that our actual performance has so closely matched our past performance. In addition to that (and somewhat ironically), Brandywine's actual performance is more "optimal" (in both absolute and risk-adjusted terms) than portfolios that were constructed with the specific intent of being "optimal."

    The focus on allocation models designed to produce the most optimal performance on past data has only served to distract investors and managers from the most critical aspect of investing - ensuring that future performance tracks past performance as closely as possible. As a result of this focus, investment performance results appear to be random. The top managers over one period fail to perform over subsequent periods. While we most certainly cannot guarantee performance results, we can at least make the statement that Brandywine's Symphony Program was developed with the prime directive of achieving the most predictable performance possible.

    Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Jul 03 12:41 PM | Link | Comment!
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