Q & A with Brandywine

Originally published in the Brandywine Asset Management Monthly Report.

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

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

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

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

Are there any counterintuitive implications to risk management that you derived from your model?
 
Certainly, the determination in the late 1980s that mean-variance optimization of a portfolio was fatally flawed was the first major counter-intuitive outcome of our research, as that was the most highly-regarded and accepted portfolio allocation model of the time (and to a large extent remains so today).
 
Second, many potential investors we talked with at that time were convinced that each individual trading strategy within our model was required to be able to “stand on its own” with regards to its risk-adjusted returns. Brandywine determined that the only relevant question at the individual strategy level was if the strategy was based on a sound logical return driver likely to provide it with a positive return over time. This led us to develop and implement many trading strategies that were, and continue to be, unique to Brandywine.
 
Please elaborate on your risk management plan. Do you have specific limits on exposure to markets/sectors or is it possible that several different portfolio strategies may signal positions in the same market/sector?
 
Brandywine’s portfolio allocation model is designed to provide balance across each strategy and market traded in the portfolio. This is intended to ensure that, over time, each market makes an equal contribution to the portfolio’s risk.

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

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

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The Value of Including Brandywine in Your Portfolio

Originally published in the Brandywine Asset Management Monthly Report.

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

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

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

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

The Abuse of Correlation (Part 2)

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

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

Let’s take a look at why.

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

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

Now let’s move from dangerous to ridiculous.

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

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

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

The Need to Understand Return Drivers

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

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

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

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The Stock Fixation

Originally published in the Brandywine Asset Management Monthly Report.

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

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

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

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

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

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

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

Please feel free to contact Rob Proctor at rob@brandywine.com if you would like to learn more about Brandywine’s Return Driver based investment philosophy and our approach to true portfolio diversification.

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Future Returns from Stocks and Bonds

This is an update to the article I wrote in mid-2013 that projected the future returns to be earned from stocks and bonds through the remainder of this decade. The article was based on research I conducted in writing my best-selling book, Jackass Investing: Don’t do it. Profit from it [i] .

Unfortunately, for people intent on adhering to a conventional 60-40 portfolio, or gambling [ii] their returns on placing money primarily in stocks, future returns do not look promising. The projected returns are lower than most people anticipate for two primary reasons:

  • The stock market rally that has taken place over the past few years has dramatically increased the multiple that people are now paying for stocks and unless “this time is different” has the effect of reducing today’s future return potential, and
  • Current profit margins have expanded to a level that is well above their long-term average. Unless “this time is different” a return to a more normal level will serve as a drag on profits over the remainder of this decade.

But before we get into the basis for my projection, let’s take a look at the three primary return drivers that power stock market returns. I outline these in the first two chapters [iii] of my book:

  1. Corporate earnings growth
  2. Investor sentiment
  3. Dividends

Now I’ll show how each of these returns drivers is projected to contribute to the future returns from stocks.

Return contribution from corporate earnings growth

Since 1900, earnings growth for companies in the S&P 500 (and its predecessor indexes) has averaged 4.73% [iv] . Because we use a 10-year average of earnings (as described in the next section) to calculate the likely level of stocks at the end of the decade, the effect of dropping off the poor earnings during the financial crisis has the effect of increasing the real 10-year average earnings growth rate over the remainder of this decade to above this level. For example, if profit margins remain at today’s level, earnings will grow at 7.19% from year-end 2013 to year-end 2020.

Unfortunately for future returns however, today’s profit margins are a fair amount above the longer-term average. Depending on the time period measured and companies included in the measurement, a ‘normal’ profit margin is approximately 7% [v] , while today’s profit margin on the S&P 500 is in the range of 9.5% [vi] . There are a number of factors that have contributed to today’s higher profit margins, among them low interest rates, constrained payroll costs and capital expenditures, and increased profits (and lower taxes) derived from non-US business. And there are those who contend that these changes are structural and will persist. Perhaps. But to accept this is to believe that “this time is different.”

As a result, I believe that profit margins are likely to decline to the longer-term average of 7% by year-end 2020. As profit margins revert towards their long-term average, earnings growth will be subdued. To expect something different is betting against the odds. The result is that corporate profits on the S&P 500 are likely to grow at a 5.53% annual rate.

Return contribution from investor sentiment

In my book I show that investor sentiment is the dominant return driver for stocks during periods of less than 20 years. Perhaps surprisingly, today, less than five years after the dramatic losses suffered by the world’s stock markets during the financial crisis, investor sentiment is approaching historical highs. This is evident in a variety of indicators, such as investor surveys [vii] and stock fund inflows [viii] . But the measure we use, which confirms the optimism exhibited by these other measures, is the cyclically-adjusted price-earnings ratio (“CAPE”).

CAPE was popularized by Robert Shiller in his book Irrational Exuberance and compares the S&P 500’s current price to the 10-year average of earnings. This has the benefit of smoothing earnings to reduce the impact of interim events, such as the financial crisis. Over the past 114 years CAPE has averaged 16.45. As of year-end 2013, due to the strong stock market rally of the past few years, CAPE has inflated to 25.09.

Unless “this time is different,” to believe that CAPE will remain at a new “permanently high plateau [ix] ” is to bet against the odds. Over the remainder of this decade CAPE is more likely to revert to its long-term average. The result will be an annual drag on stock market appreciation of -5.85% [x] .

Return contribution from dividends

The dividend yield on the S&P 500 at year-end 2013 was approximately 1.91%. This represents a dividend payout ratio of 37%. This payout ratio is quite a bit lower than the 114 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 compound this effect while also increasing along with corporate profits, I project the annual return contribution from dividends, between 2013 and the end of 2020, will be +2.62%.

Calculating the S&P 500 total return

We’re now left with a calculation to determine the projected average annual return for the S&P total return index, between year-end 2013 and year-end 2020.

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

This performance is dramatically lower than what conventional investment wisdom has led people to expect. Even if profit margins remain at today’s high levels, the total return from stocks will be, at 4.3%, only half of what people have come to expect. The math is rather straightforward. To expect a different result than what is shown here is to insist that “this time is different.”

Return contribution from bonds

For the past 32 years the Barclay Aggregate Bond Index averaged annualized returns of 8.46%. Unfortunately, the two primary return drivers that contributed to that performance, although more favorable since I wrote my original article, 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 1.75% today, [xi] and
  2. The average yield of 5.79% (on the 5-year Treasury note, which approximates the yield on the Index) over the period.

With the Barclay Aggregate Bond Index now yielding just over 2%, the likely return from bonds over the remainder of this decade (based on the fact that historically, the yield on the Barclay Aggregate Bond Index is predictive of total returns over the following 5-10 years) should be similar to the current yield on the Barclay Aggregate Bond Index, which, as represented by the iShares ETF (AGG) is 2.32%. To believe otherwise would be to believe that “this time is different.”

Calculating the return on the 60-40 portfolio

In summary then, based on the above straightforward analysis, from year-end 2013 through year-end 2020 we can expect the following return from a conventional 60-40 portfolio:

This is obviously much lower than what people have come to expect from a conventionally-diversified portfolio. It is also likely insufficient to meet most people’s financial needs. This doesn’t mean stocks couldn’t go up 30% again in 2014. They could. But they could also drop 30%. In fact, the lower projected return does not mean lower volatility. History shows that during periods with similar CAPE levels as today, volatility has actually been higher than normal [xii] . So while we’re looking at low returns over the next seven years, we’re also looking at above average volatility of those low returns. Clearly, this is a sub-optimal environment in which to entrust your money to a 60-40 “poor-folio.”

But this is not a unique situation. Conventional investment wisdom has always encouraged gambling, rather than investing. Due to its reliance on just four return drivers, the conventional 60-40 portfolio has never provided true portfolio diversification and has always exposed people to unnecessary risks relative to the potential return (my definition of “Jackass Investing”). When those four return drivers underperform, as is indicated by the projections in this article, performance will suffer, but the risks remain. The dramatic losses in 2001 and 2008 should serve as a warning. They are not exceptions.

But there is a better way.

Increasing returns and reducing risk with Return Driver based investing

Portfolio diversification is the one true “free lunch” of investing, where you can achieve both greater returns and less risk. But “true” portfolio diversification can only be obtained by diversifying your portfolio across multiple return drivers [xiii] . I give examples of a truly diversified portfolio in the final chapter [xiv] of my book, and I 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. And especially today, the odds do not favor a 60-40 gambling approach.

____________________________________________________________________

[i] Learn more about the book at www.JackassInvesting.com .

[ii] I refer to holding heavy positions in stocks as “gambling” Because people that do so are taking unnecessary risks with their money (meaning they could earn the same returns with less risk if they properly diversified their portfolios). You can read the chapter on gambling vs. investing here: http://bit.ly/utWsNy

[iii] I have made available complimentary eBook versions of the Introduction and first two chapters of my best-seller at the following links: http://tinyurl.com/qxt8e2h and http://bit.ly/xW2xuS

[iv] Robert J. Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000, 2005 updated). Data provided from a spreadsheet available at http://www.irrationalexuberance.com/

[v] David Bianco, “Deutsche Bank Securities Inc. US Equity insights,” December 12, 2013, pg. 72.

[vi] S&P reports profit margins on the S&P 500 as of June 2013 at 9.5%. Available under “Additional info, then “Index Earnings” at http://us.spindices.com/indices/equity/sp-500

[vii] The Investors Intelligence survey of December 17, 2013 shows more than four times as many bulls as bears. This is one of the highest readings in the history of the indicator and is greater than the ratio at both the 2000 and 2007 market peaks. Historically, measures greater than three are indicative of market tops.

[viii] I present an actual trading strategy based on stock fund money flows in the “Action Section” for Jackass investing). You can read about the trading strategy starting on page 19 of the Action Section at: https://jackassinvesting.com/action/index.php.

[ix] This was the famous quote pronounced by the noted economist Irving Fisher immediately prior to the stock market crash of 1929, when he stated that the stock market had reached “a permanently high plateau.” His reputation never recovered from that gaffe.

[x] If CAPE today was equal to its long-term average the S&P500 would be at 1192, a 34.45% decline from the year-end 2013 price of 1818. This equates to an annualized decline of 5.85%.

[xi] 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.

[xii] Shiller calculates that the forward three year volatility of S&P 500 is 15.55% when CAPE>=25 and 12.77% when CAPE<25.

[xiii] I discuss returns drivers in the Introduction to my book, which you can read here: http://tinyurl.com/q3eu7qm

[xiv] I have made available a complimentary eBook version of the final chapter of my best-seller at the following link: http://bit.ly/vxDo6v

 

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Performance Comparison: Brandywine vs. Stocks and Managed Futures

Originally published in the Brandywine Asset Management Monthly Report.

Brandywine launched our Brandywine Symphony program in July 2011 with funding from an initial institutional investor. Since that time we have more than doubled our assets under management and outperformed both the S&P 500 (despite its exceptional performance over that period) and managed futures traders. Here’s how that was accomplished and why we are confident about our future performance opportunities.

Brandywine compared to stocks
Over the past 2 1/2 years (July 2011 through December 2013) the S&P 500 Total Return Index (which includes reinvested dividends) gained an impressive +47.91%. Over the same period, the Brandywine Symphony Preferred Fund outperformed stocks with a +56.54% cumulative return. What is most interesting about Brandywine’s outperformance is that it was achieved without taking on the high level of event risk that is accepted by people who buy stocks.

Event risk is present when an investment is powered by one or a few Return Drivers. As Mike Dever reveals in his best-seller, stock prices are dominated by just two primary Return Drivers. (Click here to read a complimentary copy of the chapter where this is disclosed). Because Brandywine’s portfolio is diversified across dozens of Return Drivers and more than 100 global financial and commodity markets, global stock markets only account for approximately 20% of Brandywine’s positions. If an event occurs that negatively affects stock prices, it’s impact would likely be much less for Brandywine than for those with greater stock exposure. Furthermore, if you do hold long stock positions, Brandywine provides an additional benefit: our performance is uncorrelated to that of the stock market. That is because Brandywine trades in stock markets representing more than 20 countries but also holds both long and short positions.

The best exhibition of this diversification value occurred in the third quarter of 2011. During that period the S&P 500 fell more than -13% while, in stark contrast, Brandywine’s Symphony Preferred Fund gained more than +30%.

We have heard from a lot of people who feel that the only way they can get the returns they need is to buy stocks. It’s no wonder. The popular financial press presents the investment option as one big gamble: should you buy stocks or hold bonds? But the choice is actually much simpler and intellectually pure. Should you gamble your money on just a few Return Drivers, or increase potential returns and reduce risk by diversifying your money across multiple Return Drivers?

The bottom line is that you’re NOT forced to decide between earning insufficient returns or gambling with stocks. As Mike Dever pointed out in his book, and as Brandywine has demonstrated with the subsequent performance of our Brandywine Symphony Preferred Fund, we have shown that you can:

  1. achieve returns that are better than putting your money into stocks, even during this recent stock bull market
  2. earn positive returns when stocks are losing, and
  3. produce those returns without the high level of event risk embedded in holding long stock positions.

Brandywine compared to managed futures
Much has been written over the past couple of years about the difficulty that managed futures traders have had making money. Blame has been placed on market interference caused by Quantitative Easing, lack of extended trends, industry capacity… the list goes on and on. We don’t buy any of it. Traders lose money (or at least don’t produce profits) simply because their trading strategy is out of sync with the markets they trade. We know that sounds simplistic, but over the past decade, and especially after the success of trend followers during the financial crisis, the vast majority of money into managed futures flowed to trend followers. But EVERY trend following strategy we have tested or traded has had extended periods of dramatic under-performance. The past five years should not have been unexpected.

Brandywine is not anti-trend following. 20% of our portfolio is traded pursuant to strategies designed to profit from market trends. But trend-following is only ONE RETURN DRIVER. There are dozens of other Return Drivers that can be exploited and well over 100 global financial and commodity markets that can be traded in a balanced, diversified portfolio. Since we started publishing these monthly reports in 2011, we have presented a number of the Return Drivers used by Brandywine. These include sentiment-based strategies using ETF money flows to trade stock and bond markets, cost of production based trading strategies to profit in commodity markets, and directional arbitrage strategies trading in the currency and interest rate markets.

Brandywine’s Symphony program has outperformed managed futures traders, with low volatility, precisely because of our use of multiple Return Drivers to obtain true, balanced portfolio diversification. We realize we have an advantage over many other futures traders in that our 30+ years of history has provided us with the time to research and develop hundreds of trading strategies based on a myriad of Return Drivers. It’s a compilation of research that cannot be built over night. But our biggest advantage is in our investment philosophy. Brandywine doesn’t limit ourselves to one style of trading (unless you consider Return Driver-based trading as a style). We simply employ any valid trading strategy (the vast majority of which are fundamentally-based) that can be systematized and incorporated into our diversified portfolio.

The result is that Brandywine’s Symphony program has been profitable every year since we started trading in 2011 and has produced a 12%+ cumulative return with just a 7% annualized standard deviation. Although this return is below our long-term target, it is well within our short-term expectations. In contrast, the BTOP 50 was down –2.0% over the same period and the Newedge CTA index fell –2.6%.

What to expect
There is no certainty in investing. There are only probabilities. Brandywine is confident that the probability of us hitting our targets for risk and return are maximized by our multi-strategy, Return Driver based approach. We began trading Brandywine’s Symphony program in July 2011 with expectations based on our past trading experience and research. We continue to perform within those expectations. While we cannot state with certainty that the future will continue on the same path, we are confident that our approach provides us with higher probabilities of achieving our performance targets than if we were to employ a less-diversified approach.

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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.

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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.

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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.

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Investing Myths on the Dan Collins Report

Mike Dever recently submitted a series of posts for the Dan Collins Report, a blog covering the world of futures, commodities, managed futures, alternative investments, and the trading world in general.

In this series of posts, Mike Dever describes each myth from “Jackass Investing” and reveals key findings and innovations to disprove the myth.

Please click the links below for each post in this series.

Part 1: Top 20 Investment Myths – Don’t Be a Jackass

Part 2: Top 20 Investment Myths – Traditional Investing Logic and Trend Following

Part 3: Top 20 Investment Myths – The Danger of Futures

Part 4: Top 20 Investment Myths – Free Lunch Investing

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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.

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