The Benefit of “Predictive Diversification”

Originally published in the Brandywine Asset Management Monthly Report.

Throughout the summer our monthly reports focused on the “perfect” drawdown Brandywine incurred from April through July. We called it perfect because, as we described in those reports, it was right in line with what we expected based on our research and past trading. It was our confidence in our research methodology and the statistical validity of our past performance that led us to write in early July that “now may be an excellent time to invest with Brandywine.”

Another factor that prompted us to recommend new or additional investments was the increase in Brandywine’s market exposure at the end of July. Brandywine employs dozens of fundamentally-based trading strategies, each based on a unique return driver, to trade across more than 150 global financial and commodity markets. When market opportunities arise, an increasing number of those return drivers signal trading opportunities. As a result, our overall portfolio exposure across all strategies and markets is often highest during or immediately prior to our best-performing periods. This is exactly what occurred with Brandywine at the end of July.

During the drawdown (-7.55% over four months), Brandywine’s market exposure, as measured by our margin-to-equity ratio, averaged a below-average 7.81%. We pointed this out in our July report and then wrapped up the discussion by stating that on the last day of July our market exposure (measured by our margin-to-equity ratio) “increased to its highest level in more than four months” and that “this indicates that Brandywine’s Symphony Program is confident about near-term profit opportunities.” July 31 marked the low point in Brandywine’s performance for the year. Since then Brandywine’s Symphony Program has gained +7.10% and our aggressively-traded Brandywine Symphony Preferred Fund gained +30.45%. This rally was accompanied by an average margin-to-equity ratio of 9.59%.

Not every performance drawdown behaves as well as the one we experienced this past summer. And while the odds favored a performance rally at the end of July, there was of course still the possibility that the drawdown could have extended for a longer duration and greater magnitude. All we (Brandywine and our clients) can do is play the percentages, which indicated an approaching end to the drawdown.

Perhaps the best question to ask is, “Why was Brandywine so confident in the percentages?” The answer is due to our use of “Predictive Diversification.”

Predictive Diversification

Predictive Diversification was developed by Brandywine more than twenty years ago. We were systematizing our return driver based trading strategies and sought a process for allocating to each of them in our portfolio. At that time, and remaining to a large extent today, the conventional approach employed by portfolio managers to allocate across the constituents of their portfolios was to use some variation of “mean-variance” modeling such as modern portfolio theory. In this approach, which contributed to Harry Markowitz receiving the Nobel Prize in Economics in 1990, an “efficient frontier” is identified where various allocations result in the best returns for any given level of risk. Unfortunately, this model, although being academically elegant and quite precise, produces results that are simply wrong. Virtually everyone who uses this approach modifies either its inputs or its outputs (such as by using constraints) in order to avoid unrealistic results. They realize that the optimal results derived from the model are unlikely to persist in the future.

Brandywine addressed this issue in the same way we approach all research problems. By starting over. If the output of any of our research projects produces knowingly incorrect results, there is no adequate tweak that can fix it. The project must be redesigned from the start.

In applying this approach to the portfolio diversification problem, we came to realize that modern portfolio theory was the right answer to the wrong question. The question should not have been “How do I solve for the best risk-adjusted return of a portfolio?” The question should have been (and still is!), “How should I allocate within my portfolio in order to achieve the most predictable returns?” (After all, if future performance is knowingly unlikely to match the past, nothing else matters.) It was that question that led to the development of Brandywine’s Predictive Diversification portfolio allocation model. The use of Predictive Diversification, in combination with Brandywine’s return driver based trading strategies, results in portfolio allocations that are significantly different than those produced using conventional portfolio diversification models. But most importantly, Brandywine’s model results in a portfolio that gives us more confidence (than if we had employed conventional portfolio allocation methods) that past performance will carry into the future. After all, that is what we solved for.

If you’re interested in learning more about the unique research philosophy and methodologies that have contributed to Brandywine’s differentiating performance, please contact Rob Proctor or Mike Dever to set up a presentation.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Brandywine’s Outperformance

Originally published in the Brandywine Asset Management Monthly Report.

When we began trading Brandywine’s Symphony program in July 2011, we were often asked how we compared to the ‘big names’ in the managed futures industry. While we were friendly and familiar with many of those managers – in fact, Brandywine was either the first or a very early investor in some of today’s largest managers – we didn’t necessarily know the exact nature of how their trading evolved, so we weren’t able to talk specifically about how our approach compared to theirs. But we did have some general knowledge of their trading approaches and so could make some general statements.

The most significant comment we made was that we were confident that our performance would exceed theirs over the next five or ten years. Not out of hubris, but based on some straightforward observations and experience. We didn’t make this statement in any way to malign the other managers, which we respected and continue to respect today. We just felt that we had some distinct advantages that would enable us to outperform. These include:

Size

When Brandywine re-entered the business of trading outside investor money in July 2011, we did so after receiving $10 million in funding from an initial institutional investor. While we have grown since that time, our asset level remains well below that of the largest firms in the business. This provides Brandywine with a size advantage that will persist for a number of years. The two primary benefits of our size are that 1) we are able to easily employ shorter-term trading strategies and 2) we can optimally allocate to less liquid markets that are essentially unavailable to the largest managers. For example, many of our sentiment-based strategies, which have been quite profitable over the past two years, are short-term in nature and difficult to execute by the largest managers. In addition, Brandywine has profited from moves in less-liquid markets, such as the livestock markets, to which the largest managers are unable to optimally allocate.

History

Brandywine’s founder began trading in 1979, and Brandywine was formed in 1982. We managed money for some of the largest managers and, as mentioned in the opening paragraph, were early investors in other leading CTAs. Those early experiences allowed us to explore, observe and execute a tremendous variety of trading approaches. This experience throughout the 1980s served as the basis for the research methodology and investment philosophy that led to the 100% systematic Brandywine Benchmark Program that we traded successfully throughout the 1990s. The consistent performance of the Brandywine Benchmark Program and the resultant increase in our assets under management into the hundreds of millions of dollars were what first led to our recognition as being one of the industry’s leading CTAs.

Research Base

Longevity by itself is not an edge. But during Brandywine’s 30+ years we have innovated and traded numerous unique trading strategies based on sound, logical return drivers. In fact, we pioneered the use of return drivers as being a required basis for a valid trading strategy. Equally important, Brandywine also innovated new portfolio allocation models, such as the “Predictive Diversification” model used by Brandywine over the past two decades. It is these innovations, proven over time with real money at risk, that have contributed to Brandywine’s differentiating performance since the launch of Brandywine’s Symphony Program in July 2011.

The Result

As a result of the investment flexibility provided by Brandywine’s size, our 30+ years of professional experience, and our innovative research, we have been able to fulfill our expectation that we would provide our investors with industry outperformance. This is evidenced in the following chart, which compares Brandywine’s performance to that of the CTAs with which we were most frequently compared when we launched Brandywine’s Symphony Program in July 2011.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Brandywine’s Differentiating Performance

Originally published in the Brandywine Asset Management Monthly Report.

Since Brandywine’s Symphony Program began trading in July 2011, it has produced a total gain of +8.79%, while all major CTA indexes have recorded losses (for example, the BTOP 50 lost –4.67% during the period). This past month provides another great demonstration of how Brandywine can profit while other CTAs suffer losses.

The performance difference lies in Brandywine’s Return Driver based investment philosophy and our belief that the most consistent and predictable returns are earned by systematically employing broad strategy and market diversification across a balanced portfolio of fundamentally-based trading strategies. In support of this philosophy, Brandywine employs dozens of independent trading strategies, many of which were first employed by Brandywine more than two decades ago and which continue to be valid today.

A look at some of Brandywine’s trades over the past month provides a great illustration of how these time-tested trading strategies provide Brandywine with differentiating results.

Trade Example #1: Fundamentally-based trade in deferred lean hog market

This trading strategy is highly selective, trading no more than once each year, with more than 70% profitable trades. The original research in support of this strategy was developed in 1991 and the strategy remains valid today.

Trade Example #2: Interest rate directional arbitrage in New Zealand Dollar

This trading strategy utilizes interest rate differentials among currencies and within each currency’s yield curve to enter into longer-term positions. The Return Drivers underpinning this strategy are completely independent of trend following, and as you can see on the chart, this presents the opportunity for trades to be entered counter to prevailing trends. The current position was entered on June 27th and has contributed more than 30 basis points of profits to Brandywine’s performance.

Trade Example #3: Event-driven strategy signal in deferred Eurodollar market

Brandywine’s Event-driven trading strategies trace their roots back to the discretionary trading conducted by Brandywine’s founder in the 1980s. These strategies often take counter-trend positions following the release of government reports or other events. The strategy is selective, entering into approximately one trade per year per relevant market. When the current trade was entered in early September, the Eurodollar market was in a prolonged downtrend. Brandywine’s new long position was counter to that held by trend followers and while already profitable, further benefitted from a strong rally on September 18th following the decision of the U.S. Federal Reserve to delay the start of “tapering.”

With dozens of independent trading strategies trading across well over 100 markets, Brandywine employs more than 1,000 strategy-market combinations similar to those illustrated above. Each of those strategy-market combinations is based on a sound, logical Return Driver with a positive performance expectation that has withstood the test of time. The result is a fundamentally-based investment approach that is balanced across numerous positions and Return Drivers and that is not dependent on any single style of trading or market condition to achieve profits. This is in keeping with Brandywine’s belief that the most consistent and predictable returns are earned by systematically employing broad strategy and market diversification across a balanced portfolio of fundamentally-based trading strategies.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Investing, Trading & Gambling

Originally published in the Brandywine Asset Management Monthly Report.

With the U.S. stock market racing to new highs and up almost 150% since the financial crisis low in 2009, we thought it might be a good time to talk about the perception vs. reality in the financial world of the differences between investing and trading. A more complete description of this topic can be found in chapter eight of Mr. Dever’s book, which you can read by following this complimentary link: http://bit.ly/utWsNy.

Investing is often thought of as an act of entering into a position and leaving it on for an extended time. It’s been touted as being the virtuous approach. Trading is the description used to explain the act of changing those positions more frequently. It is considered “speculative’ and often referred to as gambling. The fact is that investing and trading are neither. Investing is the process of identifying the best, most rational opportunities for profiting within your means, and then unemotionally following a process that combines those opportunities into a portfolio that has a high probability of achieving the greatest returns possible while limiting risk over a specific time period. Trading (which involves the development of trading strategies based on disparate “return drivers”) is the method used to achieve that return and thus is a component of investing. In contrast, gambling is entering into or maintaining trades with a negative expected outcome or taking unnecessary risks.

Unfortunately, the process that most people have been taught to follow to earn a return on their money is not investing. It’s gambling. A person who is 60% long stocks and 40% long bonds is taking unnecessary risk. It’s not that there is a problem with being long stocks. It’s that exposing 60% of a portfolio to anything is gambling. That includes government bonds, treasury bills, and other “riskless” investments. The fact is that “angry environments” exist. These are the periods when market conditions are least suitable to any given position. To be in such an environment and not adapt is not smart. In contrast, what people refer to as gambling is often much more akin to trading. For example, a skilled poker player varies her poker play based on the hand she is dealt and the expected behavior of her opponents. She adapts. She’s not a “gambler.” That’s one of the reasons she wins at poker. The same behavior applies to investing. If you put a process in place to ensure that when you’re dealt a “bad hand”, you adapt, you are trading. If you don’t, you’re gambling. Buying and holding stocks through an angry environment is gambling.

Another way to determine if you are gambling, and not investing, is to objectively evaluate your psyche. If you are acutely aware of every fluctuation in the U.S. stock market then you certainly have too much riding on the outcome. You are gambling. If it keeps you up at night then it is a certainty you have too much exposure. If you weren’t gambling on the U.S. stock market you wouldn’t care any more about the movement in U.S. stocks than you would about the movement of orange juice, wheat, oil, or Australian dollars, which are equally tradable for individual investors.

After years of powerful stock market gains, many people, afraid of missing out on further gains such as those that have already been registered, are once again shifting towards gambling behavior by increasing their equity exposure. The memory of the pain inflicted on their portfolios during the dot-com meltdown and the financial crisis has begun to fade. But there are alternatives to long equity exposure that have the potential to produce greater returns – and with less risk – than gambling on a sizable equity position. The fact is that there are a myriad of trading strategies and markets that can be incorporated into an investment portfolio. Picking just a couple, such as being long U.S. equities or long fixed income securities is intentionally limiting and exposes the “poor-folio” to unnecessary and avoidable risks.

Brandywine has spent decades developing a wide range of trading strategies that enable us to diversify our clients’ portfolios across more than 100 global financial and commodity markets. The result is that difficult periods for Brandywine (such as the one we encountered over the past five months) produce relatively constrained losses – certainly relative to the extended and substantial losses experienced by portfolios dominated by long equity exposure. That is because our portfolio is balanced across dozens of return drivers and more than 100 global markets. If you’re interested in learning how you can invest in a truly diversified portfolio, rather than gamble on a poorly-diversified “poor-folio,” give us a call. We look forward to showing you the myriad of ways Brandywine creates a truly globally-diversified portfolio.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Controlling Losses Presents Timely Investment Opportunity

Originally published in the Brandywine Asset Management Monthly Report.

Since the end of the first quarter, Brandywine’s Symphony Program has suffered its worst peak-to-trough decline since the start of trading in July 2011. On a daily basis (as opposed to the month-end data usually reported), performance peaked on March 15, 2013 and troughed on July 31, 2013. During that 98 (trading) day period, the program dropped a total of -8.67%. Let’s look at how this compares to expectations based on our tested historical performance.

In the historical simulations for Brandywine’s Symphony Program covering the period January 1999 through June 2011 (immediately prior to the start of actual trading in the program), there were 11 peak-to-trough drawdowns (looking at daily data, not just month-end) that exceeded 8%. This amounts to one such occurrence roughly every 14 months. Based on this data, our current drawdown was a bit overdue, having arrived in our 25th month of actual trading. But what this points out is that, although every drawdown is unwelcome, they will occur, and this current drawdown is right in line with historical expectations.

The key is in controlling drawdowns; limiting their impact so when the turnaround occurs, new performance highs can be quickly achieved. (As Mr. Dever states in the final chapter of his best-selling book, “Drawdowns are the greatest impediment to high returns and are the true measure of risk”). In that regard Brandywine stacks up quite well against the most popular position in most people’s portfolios, the S&P 500. For example, despite being the largest we have incurred, the current drawdown is less than 1/6 that of the S&P 500 decline in 2007 – 2009 and less than 1/5 that of the S&P 500 decline in 2000 – 2002. Brandywine’s Symphony Program controls risk in the following ways:

  • Unlike the S&P 500, which in the short-term is dominated by one primary return driver – investor sentiment – Brandywine’s Symphony Program incorporates dozens of trading strategies, based on numerous unrelated return drivers, to trade across more than 100 global financial and commodity markets. This spreads the risk, greatly reducing the impact any single ‘event’ or change in investor sentiment will have on Brandywine’s portfolio. (You can see the primary return drivers powering stock market prices by following this complimentary link to the first chapter of Mr. Dever’s book: http://bit.ly/xrz2Ur).
  • Brandywine’s Symphony Program is designed to naturally decrease exposure when there are fewer profit-making opportunities and increase exposure when there are more opportunities. This occurs because Brandywine’s multiple trading strategies operate independently of each other. When there are fewer opportunities, fewer trading strategies signal positions.         
    Evidence of this risk reduction during negative periods is provided by Brandywine’s margin-to-equity ratio, which is a rough measure of market exposure. During down months Brandywine has averaged a M-E ratio of 7.77%, which is more than 15% lower than the ratio during Brandywine’s strongest performing months. Interestingly, (although past performance is not indicative of future performance), Brandywine’s M-E ratio increased to its highest level in more than four months on the last day of July. This indicates that Brandywine’s Symphony Program is confident about near-term profit opportunities.

This confidence reinforces the statement we made last month that “now may be an excellent time to invest with Brandywine.” We believe it is especially opportune for those who have significant investments in the U.S. stock market. Year-to-date, the S&P 500 total return index is up +19.62%. This is significantly above its long-term average (since 1970) of 10.36%. In contrast, Brandywine’s Symphony Program is down 3.00% on the year, while its expected annualized return based on past trading and research is approximately 12%. The divergence is striking and presents a great opportunity for you to diversify your portfolio.

We realize history is not a perfect guide, and past performance is not indicative of future performance, but  – to repeat what we stated last month – if you are prepared to take an analytical—rather than emotional—approach to investing, please call us to discuss how an investment with Brandywine can improve your portfolio’s overall returns and reduce your risk. The time to diversify is now, not after stocks suffer a decline.

Because we reference historical tested performance in this report, 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.

 

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Buying When There’s “Blood in the Streets”

Originally published in the Brandywine Asset Management Monthly Report.

In Jackass Investing, Mike Dever recounts the story of the siege of Paris in 1871 and the quote made famous at that time when Baron Rothschild told a new investor to “buy securities when there was blood in the streets.” We’ve seen great investors do this time after time. They take advantage of investment opportunities that others are afraid to exploit. But the average person does just the opposite. We know this with certainty (the data is presented in Mr. Dever’s book) and have based a number of Brandywine’s sentiment trading strategies on this return driver. In those strategies Brandywine looks for extremes in market sentiment to take short-term trades opposite the crowd. We apply this approach to both financial (stock indexes, interest rates) and commodity markets. If you’d like to read the chapter where Mr. Dever discusses this (along with an actual trading strategy for trading stock indexes that is revealed in the book’s Action Section), just follow this complimentary link: http://bit.ly/oDQYX8.

The same opportunity can also present itself when evaluating a manager with which to invest. Every investment manager has periods where they outperform and underperform their expected returns. Those managers with less-diversified portfolios tend to have more extreme performances, while those trading more diversified portfolios may have less extreme variations in performance. In the case of Brandywine’s Symphony program, our broad strategy and market diversification has resulted in performance volatility of less than half that of the S&P 500. At the same time we are targeting returns of 12% annually, which is in excess of those to be expected by buying and holding stocks (of course we must remind you that past performance is not indicative of future performance).

But even with a low volatility of returns, Brandywine will regularly incur losing periods. The past three months have been one such period. After reaching new performance highs at the end of March, Brandywine’s Symphony program dropped -4.63% in the 2nd quarter. A drawdown of this moderate size is expected to occur at least once each year. So the question is what to expect going forward. Using history as our guide, we see that similar losing periods are followed, on average, by a positive return of more than 18% (net to our investors) over the subsequent 12 months.

What this points out is that now may be an excellent time to invest with Brandywine. If you follow the approach used by most successful investors, although there is not “blood in the streets” (Brandywine’s diversified approach is intended to avoid such dramatic losing spells), our current drawdown may be a great opportunity to start your investment with Brandywine. In addition to performance, if you have an equity-dependent portfolio, an investment with Brandywine provides tremendous portfolio diversification. The correlation between Brandywine’s Symphony program and the S&P 500 is a (negative) -0.02.

Also, despite the strong rally in stocks and the recent decline by Brandywine, over the past two years the aggressively-traded Brandywine Symphony Preferred Fund has outperformed the S&P 500 (a +17.25% annualized return for Brandywine vs. a +12.77% return for the S&P 500 total return index.

If you are prepared to take an analytical—rather than emotional—approach to investing, please call us to discuss how an investment with Brandywine can improve your portfolio’s overall returns and reduce your risk. The time to diversify is now, not after stocks suffer a decline.

Because we reference historical tested performance in this report, 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.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Why Past Performance of a Conventional (60-40) Portfolio Is NOT Indicative of Future Performance

For the past 31 years[i], a conventionally-diversified portfolio consisting of 60% stocks and 40% bonds has provided investors with satisfying returns of +10.80% annually. This was the result of both stocks and bonds advancing strongly throughout that period. Better yet, stocks and bonds complimented each other nicely. When stocks returned +19.35% annually from the market low in 1982 to its peak in August 2000, bonds lagged somewhat (although still returning a substantial +10.34% annually). But in the period from the 2000 market peak to the 2009 market low, while stocks declined a sharp -43.51%, bonds balanced that with a strong +61.78% rally. More recently, both stocks and bonds have advanced, with the 60-40 portfolio gaining an annualized +15.36% from the market low in March 2009 to May 31, 2013.

The past 31 years was an unprecedented period for a 60-40 portfolio; one that wasn’t seen prior. In fact, as I wrote in my best-selling book, Jackass Investing: Don’t do it. Profit from it., “all of the real stock market returns over the past 111 years can be attributed to just an 18 year period – the great bull market that began in August 1982 and ended in August 2000. Without those years the real, inflation-adjusted return of stocks, without reinvesting dividends, was negative.”

Unfortunately for investors, the 60-40 results of the past 30 years aren’t likely to repeat in the near future. Here’s why not.

Return drivers for U.S. equities

There’s an ethos among equity investors that stocks provide an intrinsic return. This ethos is rooted in a depth of academic research that identifies an equity “risk premium” as the source of stock market returns. The equity risk premium is the “theory” that equities are destined to produce greater returns than less risky investments such as corporate bonds, simply because they ARE riskier.

In fact, the “research” supporting the equity risk premium is actually not research at all but merely an observation – an observation that over the past couple of centuries stock returns outperformed bonds. Then a postulate, the risk premium, was created to support that observation, which in turn was “proven” by the observed data. As you could likely surmise from the obvious circularity of the postulate and proof, this is wrong. The risk of investing in stocks has nothing at all to do with their returns. As I show in Jackass Investing, stock market returns are driven by three primary “return drivers”.

In the book’s first chapter I show how over the long term stock market returns are dominated by corporate earnings growth, and in the short-term (less than 20 years) by the multiplier (the “price/earnings” or “P/E” ratio) people are willing to pay for those earnings. The chart displaying this is reproduced here[ii]:

In the second chapter I display the fact that historically, dividends have provided 48% of the total return from U.S. equity investing over the period 1900 – 2010[iii]. (In most of the studies presented in my book and in this article, I use the S&P 500 total return index which includes dividends. The ETF that generally corresponds to the price and yield performance of the S&P 500 is SPY).

Knowing this, these were the three dominant return drivers that contributed to the stock market’s +11.88% annualized return over the past 31 years:

  1. 6.16% of the annual return was driven by the average annual profit growth of 6.16%
  2. 3.19% of the annual return was the result of the increase in the P/E ratio from 10 in 1982 to more than 23 at the end of 2012 (using the cyclically-adjusted P/E (“CAPE”) presented by Robert Shiller in his book Irrational Exuberance[iv])
  3. 2.53% of the annual return was due to the dividend rate starting the period at an historically high 6.24% in 1982 and averaging 2.53% throughout the period

Going forward, if the P/E ratio reverts to its long-term average of 16.4, corporate profits grow at their historical average of +4.70%, and dividends increase at the same rate as corporate profits (and the dividend payout ratio increases to its long-term average), stocks will appreciate at just 7.05% per year over the next decade. Here’s the arithmetic.

Future returns from U.S. equities

To determine the likely return for the S&P 500 over the remainder of this decade we need three primary inputs:

  1. The rate of earnings growth for the companies underlying the index,
  2. The most likely P/E ratio people will pay for those earnings at year-end 2020, and
  3. The dividend yield for those stocks during the period.

Let’s look at each of these in turn.

Return contribution from earnings growth

Since 1900, the nominal (before inflation) average annual growth rate for companies in the S&P 500 has been 4.7%. Over the same period the average annual inflation rate has been 3.04%. For purposes of our projections I will assume these two variables continue at the same rates into the future. While I understand there are many people who expect a substantial increase in inflation, historically, that has also resulted in an increase in the nominal (before inflation) return for the S&P 500. So if that were to occur, while the nominal return from the S&P 500 would likely increase, the real (after inflation) rate of return would, on average, remain around the historical level of 1.7%. Because of this, I project the annual return contribution from earnings growth, between 2012 and the end of 2020, will be +4.70%.

Return contribution from investor sentiment

There are a variety of methods used to calculate the price/earnings ratio of a stock or stock index. The method I will use in this article is CAPE (“Cyclically Adjusted Price Earnings Ratio”), the ratio popularized by Robert Shiller in his book Irrational Exuberance. CAPE compares the S&P 500’s current price to the 10-year average of earnings. This has the benefit of smoothing earnings volatility to reduce the short-term impact of events such as the 2008 financial crisis. Over the past 113 years, CAPE has ranged from a low of 4.46 (in the depths of the Great Depression) to a high of 48.94 (at the peak of “dot-com” hysteria in 1999). The average CAPE over that period has been 18.63.

As of year-end 2012 CAPE stood at 23.37. Part of the reason the rate was above the long-term average was because the 10-year average earnings value used in the calculation was depressed by the effects of the Great Recession of 2008. In order to make the CAPE value in 2020 appear less elevated (compared to the long-term average) than it appears today due to the Great Recession, I will continue to walk forward the earnings average of the prior 10 years from 2013 through 2020, assuming average earnings growth based on the long-term average of 4.7%. This results in a growth rate of 6.8% for the 10-year earnings average from 2013 through 2020.

As a result of the combination of the increase in the 10-year average of profit growth and CAPE reverting to its long-term average, I project the annual return contribution from investor sentiment, between 2012 and the end of 2020, will be -0.72%.

Return contribution from dividends

The dividend yield on the S&P 500 at year-end 2012 was approximately 2.20%. This represents a dividend payout ratio of 36%. This figure is quite a bit lower than the 113 year average of 59%. If the payout ratio reverts to its long-term average, this will boost the dividend yield over the remainder of this decade. As a result of this, and assuming that dividends grow at the same rate as profits, which is 4.7% per year, I project the annual return contribution from dividends, between 2012 and the end of 2020, will be +3.07%.

Calculating the S&P 500 total return

We’re now left with a simple arithmetic problem to determine the projected average annual return for the S&P total return index, between 2012 and the end of 2020.

This is the sum of the contribution from each of the three return drivers:

Future returns from bonds

For the past 31 years the Barclay Aggregate Bond Index averaged annualized returns of 8.43%. Unfortunately, the two primary return drivers that contributed to that performance are both destined to provide much lower returns in the future. They are:

  1. The capital appreciation provided as the high interest rate of 13% that prevailed at the start of the period declined to just over 1% today, and
  2. The average yield of 5.74% on the 5-year Treasury note over the period.

With the Barclay Aggregate Bond Index now yielding just over 2%, and the U.S. Treasury 5-year note yielding 1.05%, the likely return from bonds over the remainder of this decade should be similar to the current yield on the Barclay Aggregate Bond Index, which, as represented by the iShares ETF (AGG) is 2.43%.

Calculating the return on the 60-40 portfolio

In summary then, based on the above straightforward analysis, from year-end 2012 through year-end 2020 we can expect the following return from a conventional 60-40 portfolio:

This is less than 1/2 the return earned over the past 31 years and approximately 1/3 the returns produced since the Great Recession low in March 2009. As I pointed out at the beginning of this article, 60-40 has always been a risky proposition; returns are earned in a “lumpy” fashion. Without the tailwinds of low P/E, high dividend yield and high interest rates, in the future those lumpy returns will be earned in relation to a lower trendline of overall performance. Also, while these projections are based on a sound analysis of the return drivers powering the 60-40 portfolio’s performance, they are certainly not absolute. Already, in the first 5 months of the 8-year projection period (January 2013 through December 2020), the 60-40 portfolio has gained more than 5%, twice that expected from these projections.

Portfolio diversification is the one true “free lunch” of investing, where you can achieve both greater returns and less risk. But, as can be seen by its reliance on just four return drivers, the conventional 60-40 portfolio does not provide true portfolio diversification. When those four return drivers underperform, as is indicated by the projections in this article, performance will suffer. True portfolio diversification can only be obtained by increasing diversification across dozens of return drivers. I give examples of a truly diversified portfolio in the final chapter of my book, and am pleased to provide a complimentary link to that chapter here: Myth 20. While some people may prefer to gamble on a less-diversified 60-40 portfolio, as my book shows, in the longer-term, true portfolio diversification can lead to both increased returns and reduced risk.

————————————————–

[i] From the market low at the end of July 1982 through May 31, 2013.

[ii] Michael Dever, Jackass Investing: Don’t do it. Profit from it. (Thornton: Ignite Publications, 2011).

This study uses linear regression analysis to determine the degree to which variance in the S&P 500 Total Return Index over various holding periods (1, 2, 5, 10, 20 and 30 years) was explained by the changes in nominal earnings and changes in P/E. A 10 year average was used to represent both the nominal earnings and the “E” in the P/E in order to reduce the impact of economic cycles. The regression analysis included three separate regression calculations for each holding period. The first regression measured the goodness of fit for changes in average earnings versus S&P total returns. The second regression measured the goodness of fit for changes in the P/E versus S&P total return. The third regression includes the two parameters, average earnings and P/E, versus S&P 500 total returns. Since linear regression assumes orthogonality of the independent variables, that assumption was tested on all of the holding period data. The Percentage change in the nominal earnings versus the P/E ratio had R2 values ranging from 2% to 6% across all holding periods, suggesting the two regression parameters are mostly independent of each other. Furthermore, the two parameter regressions were found to explain greater than 93% of the variance in the S&P 500 total return over each holding period. Since nearly all of the variance in the S&P 500 return is captured by the two parameter regression I normalized the R2 result from each of the single parameter regressions to 100% for use in Figure 3. The use of the single parameter R2 to measure the explanatory power of the S&P 500 total return for the two regression variables is an approximation. The subtle (

[iii] Annualized return of S&P 500 TR index 1900 – 2010: +9.51%. Annualized return of S&P 500 w/o reinvesting dividends: +4.92%. Contribution of dividends = (9.51 – 4.92) / 9.51 = 48%.

[iv] The cyclically-adjusted P/E (“CAPE”) used by Robert Shiller in his book: Robert J. Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000, 2005, updated). Data used in Shiller book and for S&P 500 Total Return performance available at: http://www.econ.yale.edu/~shiller/data/ie_data.xls. Retrieved February 14, 2011.

[v] This was the rate on the 5 year U.S. government bond. Five years is used as that is the approximate average duration of the Barclay Aggregate Bond Index.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Risk Control

Originally published in the Brandywine Asset Management Monthly Report.

It’s not a cliché. The key to successful investing is to control losses. May’s loss is an endorsement of Brandywine’s approach to controlling risk. There were few bright spots in the trading of Brandywine’s Symphony program during May, yet the final loss amounted to just 3% (in contrast, the S&P 500 has lost more than 3% six times in a single day since the inception of Brandywine’s Symphony program in July 2011).

Brandywine controls risk by taking a “top-down” approach that incorporates risk management as an integral requirement in Brandywine’s portfolio allocation model. In contrast, judging by the questions we receive from investors, it is apparent that many other managers control risk by imposing constraints on the positions in their portfolio. These take the form of market and sector position limits, stop-loss limits on trades or overall portfolio stop-losses. It is Brandywine’s belief that if a portfolio allocation model suggests position sizes or permits losses that need to be constrained, then there is a flaw in that model. To correct for those flaws – after the fact – by imposing constraints, is akin to putting earrings on a pig; you can dress it up, but it ain’t pretty.

We can trace this practice (of putting earrings on a pig) back to the start of the modern era of portfolio management, the publication of Harry Markowitz’s “Portfolio Selection” in 1952. When Brandywine began its research into its portfolio allocation model in the late 1980s, we came to recognize the flaws in mean-variance modeling. (Mike Dever covered this topic specifically in his well-received presentation titled “The Fatal Flaw in Mean-Variance optimization” at the QuantInvest conference in New York City in 2012.)

The goal of mean-variance modeling is to create an “optimized” portfolio and it does so by calculating an “efficient frontier,” which indicates the allocations to be made to portfolio constituents in order to achieve the best possible return for any given level of risk (defined as volatility). Many practitioners of this type of modeling realize the output is only theoretical, and often impractical, and this is the reason they compensate for this by modifying the output from their portfolio allocation models by imposing market or sector constraints.

This points out the fatal flaw in mean-variance modeling. It was developed in answer to the wrong question. Instead of asking “how can I get the optimal results given these investment/trade inputs?”, the correct question is “how can I get the most predictable results?”. This was the question Brandywine asked when we began the process of developing our portfolio allocation model in the late 1980s.

After years of researching this issue, Brandywine concluded that the greatest probability that future performance would match past performance could be achieved by establishing balance across the markets and trading strategies employed in the portfolio. The result is that Brandywine’s portfolio allocation model is designed to ensure that, over time, each market makes an equal contribution to the portfolio’s risk. It is this portfolio balance that precludes the need for Brandywine to impose any “after-the-fact” constraints in the portfolio’s positions. It is already in balance as a natural outcome of having asked the correct question when developing the model.

Recently, others have begun to recognize the fatal flaw in mean-variance modeling. This has led to the popularization of “risk parity” investing, which attempts to allocate to portfolio constituents based on risk, rather than optimizing based on risk-adjusted return. It’s a step in the right direction and does contain some elements of what Brandywine incorporated into our portfolio allocation model more than 20 years ago. But (spoiler alert) there is a fatal flaw to that approach as well, which we will discuss in a future report.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Gambling vs. Investing

Originally published in the Brandywine Asset Management Monthly Report.

Brandywine is well known for the diversity of trading strategies we have developed over the past 30+ years and continue to employ today in Brandywine’s Symphony program. It is this strategy diversity that provides us with the opportunity to profit across a variety of market conditions and, although past performance is not predictive of future performance, to increase the probability that future returns will approximate past returns.

While Brandywine’s specific trading strategies and portfolio allocation model (which determines the allocation to be made to each trading strategy and market in the portfolio) is somewhat complex, the underlying concept upon which we base our investment philosophy is quite simple. That is, we create a portfolio that is balanced across a wide range of trading strategies, each based on a sound, logical return driver capable of providing positive returns over time. Properly employed, this approach will create a portfolio that produces greater returns with less risk than a less-diversified portfolio.

To illustrate this let’s look at a simple example using two actual trading strategies.

The first strategy is a “tail-risk” strategy designed to perform especially well during periods of financial and commodity market disruption. It has produced the following risk-return profile since the end of 1998 (the end of trading in Brandywine’s Benchmark program and the start of the simulations for Brandywine’s Symphony program [1]).

Annualized Return: 5.0%
Annualized Volatility: 23.3%
Maximum Drawdown: -44.2%
Return-to-Vol Percentage: 21%

The second strategy, in contrast to the first strategy, benefits from favorable financial market conditions.

Annualized Return: 3.7%
Annualized Volatility: 15.7%
Maximum Drawdown: -51.0%
Return-to-Vol Percentage: 24%

No one in their right mind would employ either of these two strategies as a standalone strategy in their portfolio; they’re too risky. To receive single-digit returns while risking half your money is akin to gambling. But each strategy is based on a reasonably sound return driver that would permit it to be allocated a small part (perhaps a few percent) of a portfolio. And because those return drivers are truly independent of each other, allowing one strategy to profit while the other is losing, by combining the two we get the following, much more favorable, performance:

Annualized Return: 10.3%
Annualized Volatility: 22.5%
Maximum Drawdown: -27.9%
Return-to-Vol Percentage: 45%

The tremendous benefits of “true” portfolio diversification can already begin to be seen with just these two truly independent trading strategies combined into a balanced portfolio. The annualized return of the two-strategy portfolio is more than twice as good as that of the best-performing strategy and with just half its volatility. The maximum drawdown is also significantly lower than that of either of the two strategies.

Now multiply this effect by the dozens of trading strategies incorporated into Brandywine’s Symphony program and you can understand how we achieve the ACTUAL performance results shown in these reports – where the risk-adjusted return is five times better than the average of the two strategies.

We understand that not everyone can replicate what Brandywine has built over its 30-year history. But what we can’t understand is why people would choose to gamble with their money. We say that because the second strategy shown in the above example is actually the S&P 500 total return index. Yes, the strategy that no one in their right mind would employ as a standalone strategy is the dominant strategy employed by most people in their portfolios!

Portfolio diversification is often preached but virtually never employed. Concentrating a portfolio in stocks (as well as stocks and bonds, but that’s the subject of another article) is not investing, it’s gambling. In addition to the tremendous benefits of true portfolio diversification, what this simple example shows is that the vast majority of people have been taught to gamble with their money. Instead of investing – by truly diversifying their portfolios to earn better returns with far less risk than they are taking – they choose to let substantial portions of their portfolios ride on one highly risky bet. Even if you think stocks are a good buy, why wouldn’t you find other opportunities to diversify your portfolio and reduce risk? As Brandywine has discovered, there are dozens of equally or even more compelling trading strategies that can be employed in your portfolio.

Don’t gamble – invest.

(1) Since the performance of the first strategy shown in these examples is based on back-tested (hypothetical) performance, 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.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Gambling on Stocks vs. Investing with “True” Portfolio Diversification

Originally published in the Brandywine Asset Management Monthly Report.

The vast majority of people do not maintain diversified investment portfolios. This is not necessarily their fault. They have been taught, through the popular press and by financial “professionals,” to gamble with their money. This is evidenced by the fact that when stocks and bonds rise in value, most people’s portfolios also rise in value. This shows, all by itself, that their portfolios are undiversified – a single “return driver” dominates their portfolios’ performances (as discussed in last month’s report here). As Mike Dever states in the chapter on gambling, investing and trading in his best seller, “If you are acutely aware of every fluctuation in the U.S. stock market, then you certainly have too much riding on the outcome. You are gambling.” Many financial advisors try to overcome this unfortunate situation by preaching to their clients to disregard such fluctuations and “invest for the long run.” But this doesn’t reduce the risk, it merely ignores it! If investing were a fantasy, this might make sense. (“Pay no attention to that man behind the curtain”). But it is very real, and risk must be dealt with head on.

There are two primary reasons people continue to be taught to gamble with their money. The first is based on an erroneous definition of risk. Often without even being aware of it, most people equate different with risky. Since ‘everyone’ preaches and holds portfolios dominated by stocks and bonds, it is considered risky to do something different. If you are an institutional investor whose performance is benchmarked to the S&P 500, there is career risk in deviating substantially from that index. Also, because individuals are often so fixated on the stock market, many financial advisors risk (there’s that word again) being fired by their clients if their portfolios underperform the major stock indexes. Rather than educate those clients on the benefits of true portfolio diversification versus gambling their money, they take the easier path of risking their clients’ portfolios rather than their own financial security. But for the vast majority of individuals, career risk is the wrong definition of risk. Their risk is defined by their probability of falling short of their required financial goals, such as funding a college account for their children or creating a nest-egg for retirement. Employing true portfolio diversification lowers that risk.

The second reason people continue to be taught to gamble is ignorance. Many financial professionals are not aware of the options available to diversify their clients’ portfolios. Virtually all the major financial publications, Internet web sites, TV broadcasts or certification programs define investing as buying stocks and bonds. There is an occasional mention of “alternatives” but the name itself suggests these are ‘optional’ investment opportunities—certainly not primary.

But there is one primary way to reduce portfolio risk, which is to employ “true” portfolio diversification. Brandywine does this by diversifying across dozens of return drivers and more than 100 global financial and commodity markets. The results are significant and can be seen in the stability of returns over time. Let’s take a look.

As Mike Dever points out in myth #9 of his book, “Risk Can be Measured Statistically,” volatility is a very poor measure of risk and in itself can be very volatile. This is a drawback of the Sharpe ratio – a common performance measure – which equates volatility with risk. But what is interesting is that by measuring, over longer time periods, the volatility of the Sharpe ratio, you can start to see the true risk underlying a portfolio. That is because portfolios dependent on just a few return drivers will eventually suffer significant losses when those return drivers fail to perform. This is exactly what is apparent in the chart below, which tracks the rolling 3-year Sharpe ratio for the S&P 500 and the tested performance(1) of Brandywine’s Symphony program from 2002 through June 2011. As can be seen in the chart, the Sharpe ratio for the S&P 500 varied considerably over the period while that for Brandywine’s Symphony program remained relatively stable.

This performance stability continued after the start of actual trading in Brandywine’s Symphony program in July 2011. Since that time the Sharpe ratio for Brandywine’s Symphony program, currently at 1.15, has hovered near its long-term average. On the other hand, despite the historic rally in the S&P 500 over the past few years, and the fact that its current Sharpe ratio (at 0.89) is well above its longer-term average, that value is still quite a bit below that of Brandywine’s Symphony program. This is not unexpected and provides further evidence of the global diversification value provided by an investment with Brandywine. The result is true portfolio diversification, which provides greater returns with less risk than the S&P 500.

(1) 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.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

Brandywine vs. S&P 500

Originally published in the Brandywine Asset Management Monthly Report.

You see that in these reports we compare our performance to both the BTOP50 CTA index and the S&P 500 Total Return index (which includes dividends). While it may make some sense for us to compare ourselves to other CTAs (after all, we are a CTA), we provide the comparison to the S&P 500 TR index not because there’s any relevance to the comparison, but because it is expected of us (investors seem to compare every investment to the S&P 500). In reality, however, it’s really neither sensible nor fair for us to compare our performance to the S&P 500.

It’s not sensible because the S&P 500, despite the “500” in its name, is a narrowly focused index, whose returns are powered by a limited number of “return drivers.” Mike Dever explains this (and discusses return drivers) at length throughout his best-seller, Jackass Investing: Don’t do it. Profit from it. In particular, in the opening chapter of his book, he shows how the S&P 500 index price is dominated by two primary return drivers. In the short-term, defined as less than 20 years (which for most people would be considered long-term), it is driven by changes in people’s enthusiasm for owning stocks. Longer-term, growth in corporate earnings is the dominant return driver. In stark contrast, Brandywine’s performance is driven by dozens of return drivers acting across more than 100 global financial and commodity markets.

It is this stark difference in the diversification between the S&P 500 TR index and Brandywine’s Symphony program that also makes a comparison of the two unfair. 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 is already becoming apparent. While past performance is not necessarily indicative of future performance, since the inception of Brandywine’s Symphony program in July 2011, both the program and the aggressively-traded Brandywine Symphony Preferred Fund have produced risk-adjusted returns that exceed those of the S&P 500. This is despite the fact that Brandywine has slightly underperformed expectations and the S&P 500 has produced strong returns (relative to its historical returns) over that period.

The basis for making the statement that the S&P 500 TR index will underperform Brandywine on a risk-adjusted basis is one of simple math. Brandywine’s Symphony program incorporates dozens of trading strategies that are each based on a sound, logical return driver capable of producing positive returns over time. While any single one of them may approximate the risk-return profile of the U.S. stock market (such as a 10% expected return with the probability of an occasional 50% drawdown), in combination they produce those returns with much reduced risk. As summarized in the final chapter of Mr. Dever’s book, this is due to the fact that the returns earned by any single trading strategy in Brandywine Symphony’s portfolio are unrelated to the returns earned by the other trading strategies. When one is losing, there is the potential that another is profiting.

This is the basic concept behind portfolio diversification and Modern Portfolio Theory. Unfortunately, the way MPT is taught and practiced by most people is not true investing; it’s gambling. That is because their portfolios may contain as much as 20%, 30% or even 60% long stock exposure. By creating portfolios that are dominated by long stock exposure, they are gambling their money on a single return driver (people’s enthusiasm for stocks). Brandywine’s Symphony program is also exposed to global stock markets, but as we practice ‘true’ portfolio diversification, this sector represents just 17% of the portfolio, and that portion is dynamically allocated both long and short among the stock indexes of dozens of countries. The remaining 83% of Brandywine’s portfolio is allocated to trading strategies taking positions in the currency, interest rate, metals, energy and agricultural commodity markets.

If, over time, many of these trading strategies have a positive return, then over time Brandywine’s Symphony program will produce those returns, but with substantially reduced risk. In fact, because Brandywine’s drawdowns are smaller than those of a less diversified portfolio (such as one dominated by long stock exposure), the return can actually be greater than the average return of each strategy, as the portfolio spends more time producing new profits, rather than recovering from past losses. This is how we are able to produce such high absolute returns (such as the 20%+ annualized returns of the Brandywine Symphony Preferred Fund) and risk-adjusted returns.

We find that many people allocate their money based on fear. Interestingly, the fear of missing out is often greater than the fear of losing. Because of the overwhelming focus on the “stock market,” many people fear missing out on its potential returns, when in fact they could actually exceed those returns, with less risk, by investing in a truly diversified portfolio.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink

The Abuse of Correlation

Originally published in the Brandywine Asset Management Monthly Report.

Throughout the years, we have observed an abuse of the correlation statistic in selecting managers. People seem to forget that their goal is to find managers who, when combined with each other, will increase overall portfolio returns and decrease risk (especially event risk). They are looking at correlation in order to help them find such managers, since non-correlation may be an indication of this diversification value. But instead of focusing on the goal, people have become increasingly focused on the correlation metric, which often results in them missing their goal, which is (we’re repeating ourselves here) to find managers who will increase portfolio returns and decrease risk.

Brandywine’s Symphony program has a negative –0.06 correlation to the S&P 500, a 0.07 (non) correlation to the AlphaMetrix managed futures index and a low 0.34 correlation to the Barclay CTA index. Despite that, we occasionally hear analysts report to us that they find Brandywine Symphony’s performance to be “more correlated to trend followers” than they would expect, based on the fact that our portfolio is dominated by fundamentally-based, non-trend-following trading strategies (100% systematically applied). And that may be true. We don’t specifically structure our portfolio, as do some CTAs, to be un-or-negatively correlated. We just want to make money as consistently as possible with (this is the most important condition) a high probability that future performance will match past performance. Although the majority of our portfolio is fundamentally-based, we do have a 20% exposure to trend following. When trends occur, we want to be on the right side of them, and that does boost our correlation to trend followers in those trending periods (a GOOD thing!). But what really matters is not our correlation, but our value in achieving THE GOAL, which is to “increase portfolio returns and decrease risk.” Towards that goal we succeed completely.

One indication of this is that during Brandywine’s test period 1999 through June 2011, the BTOP 50 managed futures index suffered 18 drawdowns averaging -4.74%. During those periods Brandywine’s Symphony program GAINED +0.74% and our correlation with the index during those periods was a NEGATIVE 0.06. Furthermore, in keeping with the condition that past performance must be as predictive as possible of future performance, this characteristic holds up in actual trading. Since the launch of Brandywine’s Symphony program in July 2011, the BTOP 50 suffered a -5.21% drawdown. During that same drawdown period Brandywine’s Symphony program gained +5.74%.

So why is our correlation positive overall and should it be viewed as problematic?  Well, let’s ask a simple question. . . When the BTOP 50 is up, what would you prefer if you were invested with Brandywine’s Symphony?  Would you prefer we lose money to keep our correlation negative or would you prefer we make money, at the risk that someone misusing the correlation statistic might simply view an unparsed correlation number and think that embedded in the statistic was useful information?  The only reason (the “problem” if you will) that inflates our correlation statistic, is that we make money when the trend followers make money, even though most of what we do is driven by non-trend following trading strategies.

We would contend that as long as we make money when others are losing money (which we do) and are thus negatively correlated when trend-followers are losing money (which we are) then one should treat with great caution any statistic that would lead one to allocate less to Brandywine simply because we make money when others are also making money!

One way to see our value is to simply add Brandywine’s Symphony program to a portfolio and see the effect. We encourage you to present us with your portfolio. We will run a simple analysis that shows how that portfolio would perform with various allocations made to Brandywine’s Symphony. Because of the unique return drivers incorporated in Brandywine’s Symphony program, we are confident that the inclusion of Brandywine will both increase returns and decrease risk in your portfolio.

We look forward to talking with you soon.

Share this post:
  • Facebook
  • Twitter
  • email
Permalink
Page 1 of 212