Performance and Correlation

Originally published in the Brandywine Asset Management Monthly Report.

After a solid start in October, Brandywine’s Symphony Program sold off to a slight loss at month-end. This performance continues the difficult period for the Program that began last fall. But consistent with the pattern established three months ago, gains and losses have been spread across the portfolio, as our various trading strategies continue to offset each other. This differs from the drawdown period, during which many previously uncorrelated strategies lined up to produce losses.

One thing that has been consistent throughout the drawdown and recent three months is the non-correlation of Brandywine’s returns with those of other investment managers. For example, the correlation of monthly returns of Brandywine’s Symphony Program with the BTOP 50 CTA (managed futures) index is a negative -0.04.

Brandywine is unaware of any other futures manager that has such a low correlation to other CTAs and also trades a portfolio that is broadly diversified across both markets and strategies. Usually, low correlation is achieved by trading pursuant to specialized strategies (such as short-term) or concentrating portfolios in sector-focused positions. To accomplish low correlation within a broadly diversified portfolio is unique. It is also a fundamental basis for incorporating Brandywine as a core portfolio holding. As we pointed out in our August report, despite being in our largest drawdown since inception, including Brandywine’s Symphony Program in a portfolio of CTAs both increases returns and decreases risk. The report showed the same positive benefits are also exhibited when including Brandywine in a portfolio of stocks.

But Brandywine did not launch our Symphony Program with the sole intent of providing investors with uncorrelated returns. We also, based on past performance and ongoing research, expected to earn substantial positive returns. While we were successful in accomplishing both goals over our first three years of trading, the past year – as we have pointed out in these reports – has proven to be an especially difficult period. While we can never say with certainty that a drawdown period is preparing to end (just as we were unable to foresee the drawdown beginning), we are encouraged by the more stable performance we’ve witnessed over the past few months. We encourage investors with a long-term perspective to call us to discuss how Brandywine’s unique approach can add value to your investment portfolio.

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The Psychology of Investing

Originally published in the Brandywine Asset Management Monthly Report.

Over the last week of September, Brandywine’s slight monthly profit reversed to a moderate loss, with Brandywine’s Symphony Program closing the month down -1.48% and the aggressively-traded Brandywine Symphony Preferred Fund closing down -5.47%. In contrast to July’s large sell-off, over the past two months Brandywine Symphony’s performance has fluctuated in its tightest range of the past year, as shifting sentiment and other conditions have resulted in the various strategies within the Program partially offsetting each other’s positions. Interestingly (and illustrative of Brandywine’s non-correlation to other investments), over that period the S&P 500 posted its largest trading range in more than three years.

The Psychology of Investing

“It was the best of times, it was the worst of times…” is not just the opening line to Charles Dickens’ A Tale of Two Cities, it is also an apt description of the emotions facing investors and their investment managers.

When Brandywine’s Symphony Program was hitting new performance highs in August 2014, it was the “best of times.” Over its first 38 months of trading, Brandywine’s Symphony Program had posted a Sharpe ratio of more than 1.0, in line with our high expectations. This resulted in our aggressively-traded Brandywine Symphony Preferred Fund being awarded the top Macro Fund by HFM Week (in the under $1 billion category).

But paradoxically, it was also the “worst of times” from the standpoint of what was to come. Over the ensuing 13 months (thorough September 2015) the Program and Fund suffered through their longest and deepest performance drawdowns.

This stark comparison illustrates why successful investing is such a difficult pursuit. Just as the best of times emotionally do not ensure future profits, it is often the worst of times that are the best time to invest. Take for example, March of 2009. Global stock markets had suffered through one of their most difficult periods since the Great Depression of the 1930s. Stocks had lost half or more of their value in the preceding 18 months. The news programs were filled with reasons why things would get worse before they got better. Very few people were comfortable putting money into stocks at those lows. Yet as we all know that was precisely the best of times to put money into stocks.

While individuals and even many institutional investors often succumb to these emotional swings, the most successful investment professionals have processes in place to counter, and even exploit, the negative effect of potentially damaging emotions. This is exemplified in Warren Buffett’s oft-quoted comment to “be fearful when others are greedy and greedy when others are fearful.”

Brandywine’s Approach to Controlling and Exploiting Emotions

Brandywine was founded in 1982. Over the past 33 years we have become quite familiar with the emotional swings that come with trading. Brandywine’s Symphony Program is built on that experience and the result is that our approach is designed to both manage and exploit emotions.

Our primary approach to managing emotions is to trade pursuant to a systematic trading model. Although discretion is used during the research and development of our trading model, its daily application is 100% systematic. The result is that there is no urgent impulse for Brandywine to “do something” when we’re suffering losses. We will certainly use the experience to guide us in our future research, as we want to learn from our difficulties in order to continually improve our potential future performance. But we won’t make changes on the fly, as the effectiveness of our trading model is based on its consistent application over time.

We exploit emotions by employing, as a portion of our portfolio, trading strategies designed to capture the emotional swings of market participants. This includes both periods when emotions are building and contributing to market trends, in which case some of our strategies attempt to profit from those trends; and times when market sentiment in specific markets hits what is historically an unsustainable extreme, at which time we enter into (generally shorter-term) counter-trend positions.

Of course, as we’ve seen over the past year, there will be periods where despite the positive expected returns from our strategies a majority of them will ‘get it wrong’ at the same time. That’s essentially the cause of any drawdown. However, the past two months have started to exhibit a different behavior. There has been much better balance between strategies that have performed well and those that have not. Our tight performance range is one result of this. Our currently moderate margin-to-equity ratio is another. But regardless of the short-term performance, we are confident that the best way to recover from a drawdown and to profit over the longer-term is to continue with the consistent application of our trading model.

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The Benefits of Brandywine’s Non-Correlation

Originally published in the Brandywine Asset Management Monthly Report.

August was another differentiating month for Brandywine. Our positive performance was in sharp contrast to the substantial volatility and negative returns suffered by investors in the world’s stock markets.
 
The benefit of this non-correlation is starkly evident in the following statistics:
2015_08-1

As can be seen, adding 20% Brandywine to an investment in the S&P 500 both increases returns and decreases risk. This is despite the fact that the S&P 500 total return index is just one month past its highest-ever monthly close and Brandywine is in our largest drawdown to date. In other words, because of our non-correlation with stocks, Brandywine adds value to stock portfolios not only when we’re outperforming stocks, but even when we underperform. If Brandywine can add this much value when we’re down, think of the value we add when we’re performing strongly.
 
In addition, Brandywine provides the same diversification value to a portfolio of CTAs, as the major CTA indexes all dropped during August while Brandywine gained.

And the longer-term benefits of including Brandywine are just as positive:

2015_08-2

Allocating 20% of a CTA portfolio (also referred to as managed futures) to Brandywine also both increases returns and decreases risk. And for long-term investors our current drawdown may present an excellent entry opportunity for a new investment.
 
As a bonus, Brandywine can be added to your portfolio without requiring any reallocation of existing assets. We can be purely additive. Call or email us to find out how.

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Performance Analysis

Originally published in the Brandywine Asset Management Monthly Report.

In the first 38 months of trading in Brandywine’s Symphony Program, investors earned a cumulative 27% (and investors in our aggressively-traded Brandywine Symphony Preferred Fund gained an explosive 127%). The Sharpe ratio on both programs exceeded 1.0. What made this performance stand out even more was the fact that most other futures traders posted losses throughout this period. In contrast, the past 11 months have been the most difficult on record for Brandywine Symphony, which has posted a drawdown of 16%, while other futures managers have thrived.

In this report we’ll take a look at the two periods with the intent of understanding the differences between the strong performance of the first 38 months and the more recent drawdown.

The 38 Month Rally
An evaluation of Brandywine’s performance during the positive first 38 months of trading reveals that profit contributions came from a wide range of investment strategies and markets. Moreover, these contributors varied over time. No single market, sector or investment strategy dominated over the entire period. However, the profits were not the result of one continuous move higher in performance. As you might expect, there was an ebb and flow of performance over that period. These can be shown as three distinct positive periods interspersed by two drawdown periods (prior to our most recent drawdown). The positive periods were simply the result of a majority of our investment strategies being in sync with the markets and producing profits, while the opposite was true of the drawdown periods.

Image - 201507

The 11 Month Drawdown
The current drawdown, which began 11 months ago, can best be summarized by first categorizing our trading strategies into four groups:

  • Value strategies, which include strategies based on production costs and relative value
  • Alpha Hedge strategies, which capture trends
  • Fundamental strategies
  • Sentiment strategies

The Value group encompasses a number of different strategies, each based on a distinct Return Driver. But they share the common belief that markets will revert to their true value over the longer-term. We realize that good value can turn into great value if markets trend lower. Indeed, a key characteristic of these strategies is that they often accumulate losses before their value is realized (but often, the greater the shorter-term downside, the greater the ultimate upside). Because of our understanding that these strategies can be overwhelmed and generate losses in the shorter-term, we include a separate group of strategies in the portfolio that are designed to thrive in such conditions. These are Brandywine’s “Alpha Hedge” strategies.

Alpha Hedge strategies profit from extended moves in markets (this is how they generate their “alpha”). Their performances tend to be roughly correlated with trend following or momentum strategies. One environment in which they are designed to prosper is exactly the sort of emotionally-trending markets that can be dangerous to the Value strategies. As such, they provide a great complement to Brandywine’s Value strategies (which is why we label them Alpha “Hedge”). This was seen during the drawdown. As Brandywine’s value strategies produced losses, Brandywine’s Alpha Hedge strategies worked as planned and captured profits from the very trends that caused those losses. Through June, profits from Alpha Hedge more than offset the losses from Value. Unfortunately, both groups of strategies lost during July.

Throughout the strong performance over the first 38 months, the Fundamental and Sentiment strategies tended to be Brandywine’s most consistent performers. Their performances not only complemented each other, but often the strategies categorized within these groups would profit when Value or Alpha Hedge were losing. This is the basis of Brandywine’s portfolio allocation model, which endeavors to maintain balance among the strategies and markets in the portfolio with the intent of smoothing out overall performance. This favorable characteristic was turned on its head over the last 11 months, as Brandywine’s Fundamental and Sentiment strategies contributed to the drawdown. Had the strategies simply performed as they had over the first 38 months (which was in line with expectations), there would have been no drawdown.

July’s Performance
Whereas the first 10 months of the current drawdown can be attributed to a slight profit in the Value-Alpha Hedge combination being offset by stark underperformance in Brandywine’s Fundamental and Sentiment strategies, July’s loss was fully caused by the selloff in commodities (crude was down more than 20% and all major commodity indexes fell in the double digits), which hurt the performance of the Value strategies. Unfortunately, Alpha Hedge did not serve as a hedge during the month, but actually added to the losses. The Fundamental and Sentiment strategies were essentially flat on the month. Although the final loss was in the range of what we would consider “extreme,” it was achieved by a gradual erosion of performance throughout the month, rather than by one or a few sizable down days. In fact, Brandywine’s value-at-risk (VaR) declined to its lowest levels in more than a year and our margin-to-equity ratio (another measure of market exposure), fell into the lowest decile of the past year. In other words, the portfolio allocation model did what it could do to contain losses, but pervasive losses across all strategy groups led to cumulative losses, without respite.

While we obviously cannot predict the future, past drawdowns have each been followed by strong recoveries—with the largest drawdowns being followed by the largest recoveries. And while we are disappointed in the performance of our strategies over the past year, we are confident they remain valid and are based on sound, logical Return Drivers. It is our belief that the first 38 months of Brandywine Symphony’s performance is more representative of what to expect going forward than is the past 11.

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Where’s the Alpha?

Originally published in the Brandywine Asset Management Monthly Report.

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.

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Return Drivers, Correlation and Diversification

Originally published in the Brandywine Asset Management Monthly Report.

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 Joe Gabor and we will schedule a presentation.

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Taking Alpha & Beta to the Junkyard

Originally published in the Brandywine Asset Management Monthly Report.

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:

2015_04 - Correlation

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.

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Controlling Your Destiny

Originally published in the Brandywine Asset Management Monthly Report.

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:

Table - 2015_03

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.

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What Makes Brandywine Unique

Originally published in the Brandywine Asset Management Monthly Report.

Enhance Returns and Reduce Risk

0.06 . . .
That is the (non) correlation of monthly returns of the BTOP 50 managed futures index to Brandywine’s Symphony Program.

0.19 . . .
That is the (non) correlation of monthly returns of the S&P 500 total return index to Brandywine’s Symphony Program.

Comparisons to other investment indexes, such as bonds, hedge funds or REITS show a similar characteristic. Put simply, Brandywine’s Symphony Program produces performance that is uncorrelated to virtually all other investments. This low correlation means that adding Brandywine to a portfolio of CTAs, stocks, bonds, hedge funds or most any other investment will both enhance returns and reduce risk.

What Makes Brandywine Unique
From the start, we have stressed how Brandywine’s return driver based investment methodology would produce uncorrelated returns. Investors understood that when they compared our diversified, multi-strategy approach to the “traditional” investments such as stocks and bonds, whose returns are dominated by just one or two return drivers. But because Brandywine is registered as a CTA, and trades pursuant to a systematic, diversified approach, many assumed we would be correlated to trend following CTAs.

It has become unmistakable that Brandywine’s Symphony Program is also unique among CTAs. A clear distinction is that we produce uncorrelated returns while trading systematically across a globally-diversified portfolio. Other uncorrelated CTAs achieve their non-correlation either by using discretion in their approach, focusing on specific markets, sectors or strategies (such as only employing short-term trading), or selling option premium. In contrast, Brandywine’s diversification value to a portfolio comes from our use of dozens of distinct return drivers, not a specialized focus or use of day-to-day discretion. Although we are required to state that past performance is not indicative of future performance, we believe that this diversity of strategies and markets produces more consistent, sustainable and predictable returns than the other methods used to produce uncorrelated results.

What’s perhaps even more interesting is that Brandywine’s various trading strategies are even uncorrelated with each other. The average correlation of monthly returns of each of Brandywine’s strategies to the others in our portfolio is 0.00.

What this means is that by including Brandywine’s Symphony Program in a portfolio of CTAs, we can both increase overall returns and reduce risk. For example, during the period when the BTOP 50 index suffered a sustained 5% drawdown from the start of Brandywine’s trading in 2011 through September 2013, Brandywine’s Symphony Program gained more than 8%.

Brandywine provides the same diversification value to equity investors. Although the S&P 500 has been on a tear since Brandywine’s Symphony Program began trading in 2011, the S&P 500 did suffer one significant losing period during the third quarter of 2011. During that period, while the S&P 500 fell more than 18%, Brandywine gained more than 6%.

We look forward to showing you how including Brandywine in your portfolio can enhance returns and reduce potential risk. The time to add Brandywine is now, while other investments are hitting new highs in performance.

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Winning with Defense

Originally published in the Brandywine Asset Management Monthly Report.

A record 120 million people watched the New England Patriots defeat the Seattle Seahawks in Sunday night’s closely fought Super Bowl. While there were many highlights, it is the “2nd and goal” from the one yard line with 20 seconds left in the game that will forever be etched into the minds of Seahawks fans. Instead of handing the ball to star running back Marshawn Lynch, Seahawks coach Pete Carroll called for a quick slant pass to Ricardo Lockette. It is often said that defense wins games, especially the big games like the Super Bowl, and Sunday night proved no exception. Instead of a game-winning touchdown (or at worst an incomplete pass that leads to a touchdown run by Lynch on third or fourth down), undrafted rookie safety Malcolm Butler intercepted the pass and ended Seattle’s chance for a repeat Super Bowl win. One ‘fatal’ mistake resulted in the New England Patriots taking home the Super Bowl XLIX trophy.

We repeat this play-by-play – at the risk of boring those 120 million people who watched the real game – because we’d like to stress the point that defense is perhaps even more important to successful investing than it is to winning football.

Avoiding Disaster
Brandywine’s Symphony Program is currently in its largest drawdown to date, with a
-13.94% peak-to-trough drop in value, and our aggressively-traded Brandywine Symphony Preferred is down more than 38%. While we would love to avoid all drawdowns, the key is to avoid disaster – the investing equivalent of a goal line interception. As we’ve discussed in many of these reports over the past few years, Brandywine attempts to constrain our drawdowns and improve our odds for a rapid recovery by creating a balanced portfolio that employs broad portfolio diversification across both trading strategies and markets. So, although our current drawdown is our largest, it is still within a manageable range.

But while this balanced, diversified approach improves our probabilities of avoiding disasters, it can never eliminate drawdowns. The current drawdown, which began in September, is a great case in point. Over the past five months, global markets became much more correlated with each other, as the sharp rally in the dollar and the over-supply in the oil markets triggered a succession of related market moves in bonds and commodities. The majority of Brandywine’s fundamental, sentiment and arbitrage-based trading strategies were on the wrong side of many of these moves – which is essentially the definition of what causes a drawdown. Despite this, our monthly losses have been better contained each month, as both the trading strategies and portfolio allocation model adapted to the changing market conditions. And because we have avoided disaster-sized losses, we are still “in the game” and able to apply the same game plan going forward as what made us successful in the three years leading up to our current drawdown.

From the start of trading in Brandywine’s Symphony Program in 2011, we have stressed how our systematic Return Driver based approach to trading, which includes a heavy dose of fundamental inputs, will produce returns that are uncorrelated to not only all conventional investments (such as stocks and bonds) but also to other futures traders. This is reflected in our non- correlation to the S&P 500 of 0.15 and even lower correlation to the BTOP 50 managed futures index of 0.09. A specific trade example of this non-correlation took place on January 15th, when the Swiss National Bank abandoned its support for their currency’s peg to the Euro. The majority of trend followers were caught short and suffered losses on this move. In stark contrast, Brandywine’s trading strategies recognized that despite sustained central bank intervention the Swiss Franc continued to rise against the Euro. As a result, Brandywine was net long the Swiss Franc and profited from its sharp advance on that day.

“Stay the Course” or Modify the Game Plan?
There is almost never second-guessing when a team is blowing away the competition or when an investment manager is minting money. The second-guessing only takes place when losses are incurred. While we at Brandywine have certainly scrutinized our performance closely over the course of our current drawdown, with an interest in identifying where and why the losses accrued, we are fortunate that our investment philosophy provides us the path to improvement, without the need to second guess. That is because our model was designed from the start to enable – actually require – us to develop and incorporate any additional trading strategies with the intent of further diversifying the sources of our returns. Also, as we continue to collect more real time trading and performance data, our portfolio allocation model will benefit by being able to use that information to improve the portfolio balance across both trading strategies and markets. While buying drawdowns is often difficult to do emotionally, we continue to believe that the current drawdown presents a great opportunity to initiate or add to an investment with Brandywine.

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Analysis of the Drawdown

Originally published in the Brandywine Asset Management Monthly Report.

Brandywine employs a wide variety of trading strategies, each systematically applied, to trade across more than 100 global financial and commodity markets. The intent of this broad strategy and market diversification is to enable more consistent performance across a range of market conditions. Brandywine’s Symphony Program was able to accomplish this over our first three years of trading, earning consistent returns while managed futures traders suffered their longest drawdown on record. And when trend following futures traders did have positive periods, more often than not, so did Brandywine. We also posted profits during the most difficult stock market environments, such as the third quarter of 2011. So what made the past four months different?

A number of Brandywine’s trading strategies exploit extremes in market sentiment, pricing relationships between various markets and fundamental production data to enter into positions that are often independent of market trends. In the event trends develop that are contrary to those positions, Brandywine also employs momentum strategies designed not only to independently produce profits, but also to “hedge” that fundamental and sentiment exposure by offsetting a portion of those positions.

As most of our investors and readers are well aware, the last half of 2014 contained some significant market trends, such as the collapse in the oil market and the relentless rise in the value of the dollar. These were ideal conditions for trend followers to profit, and at first Brandywine also benefitted along with them. During August 2014, a month when trend followers performed quite well, Brandywine’s Symphony Program posted its second strongest month on record. But one person’s sunrise can often be another person’s hangover.

Towards the end of August, those same market trends began to signal opportunities – based on logical return drivers and decades of historical testing – and trigger additional counter-trend positions in Brandywine’s sentiment, fundamental & arbitrage-based strategies. As trends continued to move against those positions, our momentum hedges did help to balance the portfolio and offset a portion of those losses. The result was that the cumulative loss over the last three months of the year was only slightly greater than the single month loss in September.

However, due to the number of strategies indicating those counter-trend positions and the allocations assigned to them by our portfolio allocation model, the aggregate position sizes indicated by all strategies remained counter to the prevailing trend over that period, which, by definition, created the losses.

Going Forward
Brandywine believes strongly in the value of true portfolio diversification and the benefit of maintaining balance – over time – across the strategies and markets in our portfolio. This belief is at the core of our portfolio allocation model and is designed to provide our investors with the best possible long-term risk-adjusted returns. While we continue to believe that it is the long-term that matters most, we understand the benefit in reducing short-term “pain” as well.

Fortunately, there are ways for Brandywine to reduce the probability that future drawdowns will match or exceed the current drawdown, while still preserving our long-term performance. That is because, by design, Brandywine’s research philosophy requires the regular evaluation of the validity of the return drivers underlying our current strategies and Brandywine’s portfolio allocation model easily accommodates, and our belief in continuing improvement requires, the addition of new trading strategies into the portfolio. This is a process we’ve discussed numerous times in these reports over the past few years.

So addressing the source of the current drawdown doesn’t require an overhaul of our trading model or research process, but a continuation of the process already in place. We have been students of the markets now for more than 35 years and have developed a library of potential trading strategies based on our trading experience. We are especially focused now on an evaluation of the existing strategies that contributed to the drawdown, as well as the completion of the development of additional strategies designed to thrive on aggressively-trending markets.

There is of course no way to protect against losses under all conditions. Every investment program has market environments where it is more likely to lose than to gain. And while Brandywine’s Symphony Program has generally performed well across a variety of market conditions, the drawdown of the past four months has served to remind us of the need for continuous improvement. As always, we are committed to this process.

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Drawdowns – Omen or Opportunity?

Originally published in the Brandywine Asset Management Monthly Report.

Over the past three months, Brandywine’s Symphony Program suffered its largest drawdown, -11.36%, since the start of trading in July 2011. Drawdowns are a natural part of trading and Brandywine’s Symphony Program is no exception. But for most investors, they provoke discomfort and prompt a series of questions. We know this because over our decades of trading (and yes, prior drawdowns), we have fielded a number of questions, as well as asked a number of them ourselves. In this report we’ll present some of those questions and discuss the current drawdown, as well as future expectations, in the form of a Q&A.

What caused the loss over the past three months?
Brandywine’s Symphony Program incorporates a variety of trading strategies, each based on a sound, logical return driver designed to produce a positive return over time. And since inception these trading strategies, in the aggregate, have been solidly profitable. But during the current drawdown period, September through November, a disproportionate number of those strategies incurred losses while very few produced sizable gains. Specifically, a majority of the losses were caused by fundamentally-based strategies and those we describe as directional arbitrage or that employ intermarket relationships. In our due diligence questionnaire we prepared three years ago, we identified rapid downtrends in markets as being the worst environment for those strategies. With crude oil dropping more than 40% in an uninterrupted downtrend (and 10% alone on the last day of November), and other commodities such as silver, cotton and currencies [such as the Australian dollar] mired in 10% to 30% drawdowns, those strategies hit their “perfect storm” over the past few months.

Other futures traders had some of their best performance in years, why didn’t Brandywine?
Since the inception of Brandywine’s Symphony Program in 2011 we have consistently stressed that Brandywine’s unique approach to research and trading would produce returns that were non-correlated to all other investment indexes and investment managers, including CTAs. This non-correlation was exhibited in full force in November and over the past three months. After lagging Brandywine’s performance for the three years leading up to the start of our drawdown in September, the BTOP 50 and Newedge CTA indexes each rallied approximately 8%. Despite the strong performance differential, Brandywine has still outperformed those indexes since inception. Even better, because of Brandywine’s non-correlation to those indexes, adding Brandywine to a portfolio that contains CTAs results in both increased returns and reduced risk (yes, even measuring Brandywine’s performance from the low point of the current drawdown).

What are your expectations going forward?
When Brandywine suffered a drawdown in mid-2013, we stressed in our monthly report our belief that it was an excellent time to consider investing or adding to an investment with Brandywine. That belief turned out to be prescient. In the 12 months following the Brandywine Symphony Program’s drawdown in 2013, the Program produced a solid positive return of +15.83% and the aggressively-trade Brandywine Symphony Preferred gained a substantial +65.33%.

While prudence and regulations require us to state that PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE, history leads us to expect similar strong returns going forward today. This expectation is based on our historical testing and actual trading performance. In fact, in the 12 instances (both tested and actual) where Brandywine’s Symphony Program fell by more than 8% (on a gross, end-of-day basis), the following 12 month return has averaged more than 18%. Of course, Brandywine Symphony Preferred, trading at three times standard risk, would produce substantially greater returns; although as we must also state THERE IS THE RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING WITH BRANDYWINE.

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