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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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Brandywine Asset Management
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Mike Dever
My book:
Jackass Investing: Don't do it. Profit from it.
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  • 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!
  • Today's Alpha Is Tomorrow's Beta

    In last month's report we wrote (playfully questioning) the "discovery" of momentum, value and liquidity as being valid Return Drivers affecting equity prices. Although these Return Drivers had not only been discovered decades before they subsequently became revealed by academics in the early 1990s, they had also been exploited for just as long by investors as varied as Warren Buffett, Richard Donchian and John Henry (among many, many others). In other words, these weren't "discoveries" at all. We also pointed out that as soon as the mutual fund companies and other financial marketers discovered the appetite the public had for placing money in the new hot thing, they spun out numerous "Smart Beta" funds, which is the clever marketing title that's been given to funds focusing on single strategies based on these Return Drivers.

    In the mistaken belief that investors earn a return by assuming risks not desired to be held by others (as pointed out below, this is only one of many sources of return), these selectively discovered Return Drivers have been anointed as "risk factors." They have earned a place alongside the "equity risk premium" and other academic constructs as being so well known that they have now became "beta" (or at least "smart beta") and not the treasured "alpha" that creates excess returns.

    In reality, we would contend returns have never been produced by beta. The performance of every market is based on one or more Return Drivers that are the source of the performance. Every Return Driver has a time period over which it is relevant1. Once those Return Drivers have been discovered and understood, trading strategies can be developed to exploit those Return Drivers and profit by trading in the relevant markets affected by those Return Drivers. Momentum, value and liquidity are just three of many other Return Drivers that affect equity prices. Furthermore, risk transfer is only one of many sources of potential return. Profits are not only earned by collecting a "risk premium," but they can also be earned by taking the other side of misguided, ill-informed or emotional positions that have been entered into by others.

    There is No Alpha or Beta-Only Return Drivers

    The field of behavioral finance is beginning to shed light on the fact that market returns are not simply a function of risk transfer but also caused by the inept behavior of people who are truly attempting to profit - but are incapable of making the correct decisions to do so. This is often not solely their fault. In our view many people are oblivious to the process required to invest correctly. They are seriously misled by the glut of misinformation published in the popular financial press and the reactionary behavior of gurus and other talking heads. In addition, they are poorly served by the academic constructs such as risk premium (which is merely a grandiose label given to a simple observation of past market behavior), and the massive attention placed on "diversifying" across "asset classes" (This will be the topic of a future report). As a result the vast majority of people will employ a gambling mentality that assures that over time they will transfer their money to more disciplined investors.

    In contrast, it is only through a sound understanding of the valid Return Drivers that affect each market that a repeatable process for positive investment returns can be developed.

    Brandywine's Return Drivers

    Over our 30+ year history of research and trading, Brandywine has developed and time-tested (with real money) a sizable number of Return Drivers. Many of these remain valid and are employed today. Although we have disclosed some of these Return Drivers2, it would be adverse to our investment edge to reveal them all. In the parlance of the investment industry, to do so, over time, would convert the "alpha" generated by those strategies today into "smart beta" and ultimately just "beta," at some point in the future.

    To do that would violate the trust we have with our investors to protect their best interests. But without revealing the specific trading strategies, we can disclose some actual trades generated by them.

    Trade Examples

    Lean Hogs

    One strategy that provides a great illustration of the types of differentiating trades entered into by Brandywine's Symphony Program is one based on U.S. livestock market fundamentals. It initiated a trade in the lean hog market near the lows reached in August 2013 and held that position until the market peak in April 2014. Brandywine, despite employing a fully systematic trading model, often enters into trades such as this that appear to be more "discretionary" than "systematic."

    (click to enlarge)

    S&P 500

    In Myth #3 of Mr. Dever's book he presents examples of how people mis-time their trades by doing the opposite of what they should do (this is not a secret, Daniel Kahneman and Amos Tversky began research into such behavior in the 1970s). Brandywine incorporates a number of sentiment-based trading strategies to exploit this behavior across a wide range of markets. The trade below was based on one variation of a strategy disclosed by Mr. Dever in his book.

    (click to enlarge)

    Balanced Diversification vs. Concentration. Discretionary vs. Systematic.

    One key take-away from these trades, which is just a small sample of the many trades entered into by Brandywine in any given month, is that Brandywine is agnostic to the source of our returns. We don't care whether they come from long positions in stock indexes or lean hogs, short positions in the Australian dollar, or a spread position in soybeans. As long as they are based on a sound, logical Return Driver, Brandywine will exploit these opportunities. Because of this, Brandywine's trades often appear to be "discretionary" (based on an individual processing the data and deciding on a trade). In fact, however, while Brandywine employs significant discretion in the creation and development of its trading strategies, the application of those strategies in our actual trading is completely systematic.

    The reason Brandywine employs a diversity of seemingly discretionary trading strategies in a fully systematic trading program is due to the result of extensive research Brandywine conducted beginning in the late 1980s. That research made clear that the most consistent and predictable returns are earned by systematically employing broad strategy and market diversification across a balanced portfolio of fundamental, Return Driver-based trading strategies. The key is to maintain balance across those Return Drivers and markets so that, over time, no single Return Driver or market will dominate performance.

    As always, please reach out to us with any questions you may have.

    (1) Exploiting the Myths: Profiting from Wall Street's misguided beliefs (which became a Kindle best-seller under the popular title Jackass Investing: Don't do it. Profit from it.); in the "takeaways" for Myth #1 on page 17.

    (2) One strategy revealed in its entirety was designed to exploit people's tendency to do the opposite of what they should do, as described in Myth #3 of Mr. Dever's book. That strategy has contributed positively to Brandywine's performance since it was introduced into the portfolio following its release to the public. A trade example in the S&P 500 from a variant of this strategy is displayed on the prior page.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Jun 03 11:25 AM | Link | Comment!
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