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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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  • Where’s The Alpha?

    At a dinner in late 2013, Brandywine's principals spent some time talking with the alternatives head at one of the large research firms. She made the comment that it appeared to be getting more and more difficult to capture alpha (excess returns over those earned simply by buying the "market"). We've continued to hear this refrain from others more recently as well. For readers of these reports, you understand that alpha is simply the term people use to describe Return Drivers that are not yet widely disseminated or accepted in the public domain. Which means that, almost by definition, alpha should always be difficult to find, as it's only alpha if its not commonly known!

    But that's not the reason people state alpha is hard to find. The primary reason for those comments is that most people do not yet embrace a Return Driver based approach to investing and instead try to uncover alpha by looking in the same places that others are looking. Unfortunately, it's over-tilled ground and unlikely to be fertile territory for new discoveries.

    In contrast, it's our belief that there are numerous sources of alpha available to be exploited. Brandywine has looked at hundreds of potential Return Drivers and we have been comfortable enough with a few dozen of them to incorporate them into the investment strategies used in Brandywine's Symphony Program. Without getting into specifics (obviously, we need to be careful not to expose our sources of alpha lest we turn them into 'smart beta'), let's look at a recent example of two that have contributed to Brandywine's positive performance this year.

    A number of Brandywine's investment strategies are based on Return Drivers designed to exploit people's behavior. Over the past few decades, due to the excellent research conducted by people like Amos Tversky and Daniel Kahneman, what many previously suspected has been proven. For a variety of reasons, the average person is a terrible investor. The vast majority of people underperform the very funds into which they invest- by as much as 5% per year on average. This indicates the potential for an investment strategy based on a Return Driver designed to exploit this behavior by 'fading' the crowd. In particular, one of Brandywine's strategies captures returns by looking at money flows into and out of bond and stock market ETFs. When the flows indicate irrational exuberance, the strategy takes short positions and in periods of despair, the strategy potentially enters into long positions. While many other futures managers have struggled in 2015, this approach proved profitable throughout the first half of this year.

    A second strategy, also designed to exploit people's behavior, uses measures that indicate people's expectations for future price levels in a broad range of markets. It uses this information to selectively enter into positions in deferred futures contracts. Investment strategies based on this Return Driver have been Brandywine's strongest performers to date in 2015.

    Because these strategies are based on Return Drivers that exploit human behavior, we don't expect them to be negatively affected by some of the 'usual' excuses assigned to the apparent decline in other sources of alpha, such as central bank intervention, high frequency trading or the globalization of markets.

    But these are only a couple of the dozens of Return Driver based investment strategies employed by Brandywine. There are dozens, if not hundreds, of other relevant Return Drivers that can be developed into strategies to profit from the movement of hundreds of other markets. This provides the fuel for Brandywine's ongoing research.

    Jul 07 11:36 AM | Link | Comment!
  • 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!
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