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 Rob Proctor or 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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Predicting Performance

Originally published in the Brandywine Asset Management Monthly Report.

If there was ever a heading that would attract the attention of regulators, this could be it. That is because there is no accurate way to truly predict performance. In fact, every document we send out clearly states in bold type at the bottom of every page, that “PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS. THERE IS THE RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING WITH BRANDYWINE.”

The fact is that there is only the ability to estimate probabilities of performance, and even those estimates have probabilities associated with them. That said, we were reasonably confident in making this statement to a potential investor in Brandywine Symphony Preferred Fund earlier this year, “You WILL incur a 30%+ drawdown at some point if you invest in Brandywine Symphony Preferred Fund.”

That was because every measure of Brandywine’s past performance , both actual and tested, pointed to Brandywine’s Symphony Program incurring a 10% drawdown. And since the Brandywine Symphony Preferred Fund trades at three times the risk level of Brandywine’s Symphony, a 30% drawdown was, and is, expected.

Although we haven’t quite reached that level, at -27.50%, the drawdown of September—October brings us close to that level. It may seem to be a strange word to use, but we were confident we would incur that loss, precisely because of the confidence we place in our research process.

We included a chart in last month’s report that showed the 16 largest drawdowns over the past (almost) 16 years (which includes 12.5 years of tested performance and close to 3.5 years of actual performance). That chart, which is updated and reproduced here, shows that Brandywine’s Symphony Program, measured on a gross return, end-of-day basis, should average a drawdown of between 7.25% and 11.64% once each year.

Image - 201410

This shows the current drawdown as being right in line with expectations, as we should incur a drawdown of this size approximately once every three years (and we just completed our 40th month of actual trading). So this raises the question – is this investible information? Does the fact that Brandywine’s Symphony Program has reached an expected drawdown level indicate that it is time to invest? Perhaps. When we incurred our drawdown last year (which, as illustrated by the other light colored bar on the chart, reached a peak intra-month level based on gross performance of -8.38% at the end of July 2013), we stated that “now may be an excellent time to invest with Brandywine.” Since that time—including (and despite) the current drawdown—an investment in Brandywine’s Symphony has returned +9.67% (and an investment in Brandywine Symphony Preferred Fund has gained more than +36%).

We feel we are in a similar position today. And to paraphrase what we said then, we realize history is not a perfect guide, and past performance is not indicative of future performance, but if you are prepared to take an analytical—rather than emotional—approach to investing, now may be a good time to consider Brandywine.

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Benchmark-itis

Originally published in the Brandywine Asset Management Monthly Report.

The investment world lives by benchmarks. Every institutional investor benchmarks the performance of the individual components of their portfolio to various indexes. Individual investors do the same. That’s why the financial news constantly refreshes the current performance of the Dow Industrials or the S&P 500. This is partly due to regulatory mandate. In 1998 the SEC began to require mutual funds to show their performance relative to a benchmark. They felt this would better enable investors to determine whether a fund was performing well because of investment decisions made by its manager or simply because of factors outside their control. But mostly, benchmarking is seen as a necessary exercise to determine the effectiveness of a fund’s management team.

As a result of this “benchmark-itis,” we often get asked by investors, “against which benchmark should we compare your performance?” Suggestions include the S&P 500 (because everyone watches that), hedge fund indexes (because our return driver based approach is “non-traditional”), or maybe the CTA indexes (since we execute our strategies in the futures markets).

But none of these are a proper benchmark for Brandywine’s Symphony Program. That’s because Brandywine doesn’t employ trading strategies based on common, “public domain” return drivers. As a result, our returns won’t necessarily have any relationship to any index return. For example, some of Brandywine Symphony’s best-performing periods have occurred when stocks dropped significantly (such as during Q3 2011). And Brandywine shows no correlation of returns to any of the few dozen hedge fund indexes. With regards to CTA indexes, well, this year provides a great example of how uncorrelated Brandywine is. While most of the CTA indexes exhibited losses from January through July, Brandywine produced solid profits. And although Brandywine gained strongly along with the CTA indexes in August, our sharp loss in September was in stark contrast to gains for the CTA indexes. Whether we over- or under-perform relative to any of the standard benchmarks over any period of time is essentially random and irrelevant.

Brandywine’s Benchmark
So what is the best index with which to compare Brandywine Symphony’s performance? It’s our own past performance.

The reason is because Brandywine’s Symphony Program follows a return driver based approach that incorporates dozens of independent trading strategies, each based on a sound logical, non-public domain return driver, to trade across more than 100 global financial and commodity markets. Our goal is to achieve the highest possible return for any given level of risk with a reasonable probability that our future performance will match our past performance. We do not employ a single style that can be reflected in any single index.

Which leads to the question, “how is Brandywine’s Symphony Program performing relative to its benchmark (its own past performance)?” Since September posted the worst monthly loss since Brandywine’s Symphony Program began actual trading in July 2011, we’ll focus on the downside behavior.

Brandywine’s walk-forward back-test for our Symphony Program runs from January 1999 up to the start of our actual trading in July 2011(1). Virtually all performance tracking services publish an investment program’s maximum drawdown on a month-end basis (measuring the drop in performance across one or more months from the highest month-end peak to a subsequent month-end low). We’ll look at our drawdowns on that basis as well as gross end-of-day performance (which will almost always be larger as it captures intra-month losses and does not receive any benefit from potential incentive fee give-backs).

Brandywine Symphony’s Drawdowns in Line With Benchmark
In the first chart we display the 16 largest month-end peak-to-trough drawdowns (on a net basis) over the past 16 years (this includes tested performance (dark bars) from 1999 through June 2011 and actual performance (light bars) starting in July 2011). We would expect to incur a drawdown within the range of this chart on average once per year, and that is exactly what has happened. Since the start of actual trading in July 2011 we have had three drawdowns make it onto the chart. The most recent drawdown, which has been almost perfectly bracketed by the beginning and end of September (making the end-of-day performance match the month-end performance quite closely), is right in the middle of the range at -6.46% (this also indicates that it could extend an additional 3% and still remain within expectations).

201409 Image 1

Now let’s look at the 16 largest drawdowns as measured on a gross, end-of-day basis. We would expect a drawdown to fall within this range on average once per year. As you can see in the following chart, the current drawdown, at -7.14%, just made it onto the chart. Since the start of actual trading in July 2011, two drawdowns made the “bottom 16” and neither registered among the worst. So our performance in actual trading has been slightly less “risky” than our benchmark would project.

201409 Image 2

One final way to view the current drawdown is to compare this past month’s performance to other 22-day periods (the number of trading days there were in September) in our history. In that regard, this is the 5th deepest 22-day drawdown (measuring the worst 22-day period within all past drawdowns) over the past 16 years. This indicates that a drawdown of this size should occur over a 22-day period once every 3 years. Since we just wrapped up 3 ¼ years of trading, this drawdown is right in line with expectations.

Drawdowns are just as much a part of the performance of Brandywine’s Symphony Program (as well as any investment) as are positive returns. The fact that the drawdowns we have incurred in our actual trading so closely match our Benchmark expectations is confirmation that our investment model continues to work as expected. In summary, the performance of Brandywine’s Symphony Program, as measured by the drawdowns we have incurred since the start of actual trading in July 2011, has been faithfully tracking our expectations pursuant to our benchmark, which is our past performance.

(1) Because this report includes the results of the tested performance, in addition to the actual performance, of Brandywine’s Symphony program, the following disclaimer is required:

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

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The Constraint of Asset Classes

Originally published in the Brandywine Asset Management Monthly Report.

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

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

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

From Asset Classes to Return Drivers
One of the innovations supporting Brandywine’s investment philosophy is our use of return drivers. As Mike Dever states in his book, “a return driver is the primary underlying condition that drives the price of a market” and “every return driver has a time period (and markets) over which it is relevant.” Realizing that the best way to explain the return driver concept is by example, in the opening chapter of his book Mike displays the result of research that shows the relative influence of the two primary return drivers that power stock prices (which are people’s sentiment towards stocks and the growth of corporate earnings). You can read a complimentary copy of the book’s Introduction and first chapter here: http://www.brandywine.com/pdf/special/JackassInvesting_BookThruMyth1.pdf.

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

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

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

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

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

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

Resources
The myth that portfolio diversification can be achieved by allocating money across asset classes is exposed in Chapter 17 of Mr. Dever’s book. You can read a complimentary copy of that chapter here: http://www.brandywine.com/pdf/special/JackassInvesting_Myth17.pdf.

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