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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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  • Q & A With Brandywine

    Over the past few decades Brandywine has built a reputation as being an innovator. While this has served us well from a performance-standpoint, it has often led to confusion when investors attempted to fit us into the investment manager categories they had created. For example, being systematic, as we are, often leads people to believe we must be a trend follower, which we are not. Or it leads to the assumption that we do not use fundamental information, which we do. Over the years we have accumulated our answers to some of the most common questions and compiled these into a rather extensive Q&A document. We thought we'd post some of those related to our trading and risk management philosophy in this month's report:

    Please provide your insight into the behavior of markets. What market inefficiencies do you attempt to capture and why are these inefficiencies exploitable?

    Brandywine does not attempt to exploit any single market inefficiency. Each trading strategy is developed by Brandywine with the intent of capturing returns from a specific Return Driver. There are numerous biases in people's behavior related to trading/investing/gambling, and Brandywine seeks to exploit those biases. (This philosophy led to Mr. Dever writing his book Exploiting the Myths: Profiting from Wall Street's misguided beliefs (which became a best-seller under the popular title Jackass Investing).

    These biases include the desire to "trade with the crowd," anchoring biases, risk aversion, and numerous other behaviors and emotional responses that create inefficiencies that lead to the development of profitable trading strategies. These strategies provide excellent potential returns and diversification value in a 'rationally-structured' portfolio such as Brandywine's. For example, in Myth #3 of Mr. Dever's book, titled "You Can't Time the Market," Mr. Dever shows that precisely because the majority of people buy and sell U.S. equities at the wrong time, if you can measure this activity you can fade it for profit. In the Action Section for the book, he presents a specific trading strategy that does exactly this by measuring the money flows into and out of U.S. equity ETFs. Other trading strategies gain their edge by the fact that they are 'hard' to trade. For example, they may be subject to high volatility of returns. Many traders prefer strategies with low volatility and therefore ignore exploiting sound return drivers that result in positive and predictable returns over time if those returns are too volatile. These strategies provide excellent positive returns and diversification value in a portfolio such as Brandywine's.

    Are there any counterintuitive implications to risk management that you derived from your model?

    Certainly, the determination in the late 1980s that mean-variance optimization of a portfolio was fatally flawed was the first major counter-intuitive outcome of our research, as that was the most highly-regarded and accepted portfolio allocation model of the time (and to a large extent remains so today).

    Second, many potential investors we talked with at that time were convinced that each individual trading strategy within our model was required to be able to "stand on its own" with regards to its risk-adjusted returns. Brandywine determined that the only relevant question at the individual strategy level was if the strategy was based on a sound logical return driver likely to provide it with a positive return over time. This led us to develop and implement many trading strategies that were, and continue to be, unique to Brandywine.

    Please elaborate on your risk management plan. Do you have specific limits on exposure to markets/sectors or is it possible that several different portfolio strategies may signal positions in the same market/sector?

    Brandywine's portfolio allocation model is designed to provide balance across each strategy and market traded in the portfolio. This is intended to ensure that, over time, each market makes an equal contribution to the portfolio's risk.

    Brandywine takes a very "top-down" approach to risk management and portfolio allocation. Our belief is that if a portfolio allocation model results in a significant overweight of a market or related (correlated) group of markets, that is a symptom of a flaw in that model. Mike Dever covered this topic specifically in his well-received presentation titled "The Fatal Flaw in Mean-Variance Optimization" at the QuantInvest conference in NYC in 2012. Many managers address the flaw in their portfolio allocation models by imposing market or sector constraints, essentially putting a band-aid on the wound created by an incorrect (damaging) portfolio allocation model. Brandywine's goal when Mike Dever developed our portfolio allocation model in the late 1980s - early 1990s was to create a model that - first and foremost - produced future results that matched, as closely as possible, past results. As logical as that sounds, it was novel then and continues to remain novel today. Most managers base the success of their portfolio allocation / risk management models on how well they "optimize" returns on past data, not on how well future returns are likely to match those past returns. They start their research by asking the wrong question - ("How can I get the best results?", rather than "How can I get the most predictable results?"). Many (most) managers make that initial critical mistake of optimization vs. predictability. We discussed our "Predictive Diversification" portfolio allocation model in our November 2013 monthly report.

    In response to the specific question:

    YES - several of the underlying trading strategies can pick the same contract or market, but
    NO, by design the portfolio allocation model will not significantly overweight any market. However, because multiple trading strategies agree on a specific trade/position, there is a higher probability that will be a successful trade. Our portfolio allocation model then naturally allocates more to higher probability opportunities but within the construct that future performance will continue to match past performance. So in summary, we WANT to have heavier allocations to positions when multiple trading strategies are in agreement.

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

    Apr 03 10:07 AM | Link | Comment!
  • The Value Of Including Brandywine In Your Portfolio

    The addition of Brandywine to a portfolio containing stocks or managed futures can both increase returns and decrease risk. This is clearly evident in the following two metrics.

    First, performance: Since we launched Brandywine's Symphony program in July 2011 it has gained +18.69% while both the BTOP 50 and Newedge managed futures indexes have fallen (-3.00% and -4.42%, respectively). Brandywine's more aggressively managed Symphony Preferred gained +88.51%, outperforming the +49.33% earned by the S&P 500 total return index. Clearly, adding Brandywine to a portfolio that contains either managed futures or stocks would have increased returns.

    Second, diversification value: Brandywine has made money when stocks or managed futures have lost. This, of course, is obvious when looking at Brandywine's positive performance versus the losses in the managed futures indexes. But the same benefit is even more evident when comparing Brandywine to the S&P 500. For example, when the S&P 500 dropped -13.87% from July through September 2011, Brandywine's Symphony Preferred gained +30.94%. So adding Brandywine to a portfolio that contains either managed futures or stocks would also have decreased drawdowns (risk).

    Looking at our results, the diversification value of including Brandywine in an investment portfolio is obvious. This value has not gone unnoticed, as is evidenced by our growth in assets and interest from new investors. That said, some of the conventional metrics used by asset allocators not only disguise this value, but actually lead uninformed investors to reach the exact opposite conclusion.

    The Abuse of Correlation (Part 2)

    In our January 2013 report we discussed how correlation metrics are easily and often abused by investors. In this report, we'll give a further example of why correlation statistics can be misleading at best, dangerous at worst, or even downright ridiculous.

    Newedge publishes statistical reports on a number of investment managers, including Brandywine. One of the measures they provide is the correlation of monthly returns between Brandywine's Symphony program and the Newedge CTA index. The correlation data is what you would expect from looking at Brandywine's differentiating performance over the past few years. In both up and down months for the Newedge Index, Brandywine's correlation to the index has been less than 0.1 (meaning there is no correlation of returns). However, despite Brandywine's strong out-performance, (the result of our use of innovations such as Return Drivers and Predictive Diversification) and obvious portfolio diversification value, it is possible that some investors could exclude Brandywine from their portfolio because they consider us too correlated to the other investments they hold.

    Let's take a look at why.

    The chart below shows the performance of Brandywine's Symphony program compared with that of the Newedge managed futures index during February. Clearly, Brandywine's consistent profits throughout the month and strongly positive return of +5.70% were highly dissimilar to the underperformance recorded by the Newedge index. This simple chart makes it clear that there's no question that including Brandywine in the portfolio would have added significant value during the month.

    But during February, Brandywine's correlation of daily returns to the Newedge Index increased significantly, recording a value of +0.62 during the month. Sure, there were some days where the Newedge Index posted a gain and Brandywine did as well (who wouldn't want that?). But of the nine days when the Newedge index fell, Brandywine gained in five of them. And Brandywine didn't outperform by taking on more leverage; both Brandywine and the Newedge index posted an identical 42 basis point standard deviation of daily returns. This is exactly the kind of diversification value you want to see in a manager. Yet someone focused on the daily correlation metric would have concluded that Brandywine provided little diversification value - the correlation was too high. This is a clear example of where a reliance on correlation proves dangerous to an investor's financial well-being.

    Now let's move from dangerous to ridiculous.

    For most of the month of February, the Newedge index was showing a loss. Had the month ended that way, you would expect that the already low 0.09 correlation between Brandywine and Newedge during down months of the Newedge Index would have collapsed, or even gone negative. After all, Brandywine was up a sizable amount and the Newedge Index was showing a loss. But perversely, that's just not so. In fact, had the month ended on February 20th, at which time the Newedge index showed a -0.5% loss and Brandywine's Symphony program showed a +4.0% profit, the correlation of monthly returns during down months of the Newedge index would have increased from 0.09 to 0.24! Despite the stark contrast in our performances, an investor relying on the correlation metric would have concluded there was a decrease in the diversification value provided by Brandywine!

    But it gets even more ridiculous. Had Brandywine performed the exact opposite on a daily basis as it had in February [had we lost -5.70% rather than gained +5.70%], our daily correlation would have measured -0.62. This would have made Brandywine more attractive to an investor focused on correlation than did our actual significant positive performance!

    When it comes to correlation, sometimes it's better to lose than to win.

    The Need to Understand Return Drivers

    This makes clear the serious shortcoming in using correlation to find managers that can add diversification value to a portfolio. The real problem is that correlation tells you nothing about the "true" diversification value inherent in a manager's trading. True diversification value (as well as true risk, a topic for another report) can only be determined with an understanding of the Return Drivers powering the manager's performance.

    Because of this, Brandywine has been more open than most managers in revealing the sources of our returns. In fact, we have openly presented one of our actual trading strategies on the Web (and at the end of this narrative, we provide links to our past monthly reports* where we discussed some of our trading strategies and their primary Return Drivers). We realize that many managers, who may only have a single Return Driver underlying their trading strategies, are necessarily more opaque and unwilling to divulge their single secret. This is what forces investors to revert to using proxies such as correlation in place of understanding the actual Return Drivers. But because of the inability of correlation to provide any reasonably useful information, if the ability exists to understand the underlying Return Drivers, correlation should be discarded as a measure.

    *Brandywine's Monthly Reports where we discussed specific trading strategies: 2011-08, 2011-09, 2011-10, 2012-06, 2012-08, 2013-09.

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

    Tags: Correlation
    Mar 04 10:58 AM | Link | Comment!
  • The Stock Fixation

    Last month, Mike Dever published an article titled "The Future Returns from Stocks and Bonds" that used simple math to establish a price level (and total return) for stocks and bonds at the end of this decade. It wasn't the result of his research that we found the most interesting (but if you want to see why the S&P 500 is projected to be lower at the end of the decade than it was at year-end 2013, you can read the article here), it was the comments we received from readers of the article. There was one comment that epitomized the gambling mentality of the average "investor." In referring to those pundits who have been incorrectly predicting a decline in stock prices ever since the financial crisis, he wrote: "Anybody that listened to them for the past five years is in a world of hurt."

    We're not arguing those pundits weren't wrong. Clearly, stocks rallied sharply throughout that period. But it shouldn't have mattered significantly. Here's how Mr. Dever's response summed up the core investment philosophy underlying Brandywine's trading:

    "If a 12-year (as of five years ago) projection of what returns would be earned by passively putting money into the S&P 500 has a significant impact on the performance of a person's portfolio - if it resulted in them being in a "world of hurt" if they were wrong - then they're not an investor. They're a gambler. They have far too much riding on one single decision.

    The performance of the S&P 500 should have no greater impact on the performance of a person's portfolio than that of the sugar market, or dollar, or Korean stocks or any number of the hundred plus other active global financial and commodity markets. There are legitimate Return Drivers that can be exploited to profit from trading in those markets as certainly as there are Return Drivers to be exploited to profit from trading in the S&P 500."

    The "world of hurt" comment points out the fixation people have on owning stocks as a major portion of their investment portfolio and it continues to amaze us as to how many people continue to bet their savings on a single Return Driver. As Mike Dever shows in the opening chapter of Exploiting the Myths (also released under the best-selling title Jackass Investing), in periods of less than 20 years, stock market prices are dominated by investor sentiment. It is gambling to bet a substantial portion of a portfolio on that single Return Driver.

    From the standpoint of seeking the greatest returns while being exposed to the lowest risk of achieving those returns, any of the 100+ actively traded global financial and commodity markets should be just as important to investors as the U.S. stock market. Yet there is virtually no discussion among investors about Australian bonds, coffee prices, or sugar - while the stock market dominates the news. Why isn't there a C(offee)NBC discussing freeze potential, new export markets, diseases affecting the coffee crop, etc.? For the reason that not enough people care. Because stocks dominate the financial news, people buy stocks. Because people buy stocks, the financial media panders to that exposure.

    The result is a gambling mentality - where the price activity of a single market dominates a person's wealth. The financial media and professionals promise safety and diversification, but deliver roulette. You are not constrained by this mentality. You don't need to gamble on stock market event risk to earn stock market returns. In fact, by diversifying across Return Drivers you can target even higher returns while also reducing risk. This is the basis of true portfolio diversification. Its effectiveness is evidenced by the performance of Brandywine's Symphony Preferred, which has not only outperformed stocks over the strong bull market of the past few years, but also gained in January when stocks fell globally.

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

    Tags: SPY
    Feb 06 9:37 AM | Link | Comment!
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