Originally published in the Brandywine Asset Management Monthly Report.

2012 was the second consecutive losing year for the BTOP 50 managed futures index. This is the first back-to-back annual loss for the index since its inception 26 years ago. Systematic and diversified CTAs performed even worse than the broader index.

In contrast, Brandywine posted its second consecutive profitable year since the launch of Brandywine’s Symphony program in July 2011. So why has Brandywine – a systematic, diversified CTA – performed so well when our peers have not? The answer is rooted in our extensive history and unique investment philosophy.

Brandywine’s Innovations

Brandywine’s difference is not just one of performance, but one of design. Brandywine’s Symphony program was based on, and is the culmination of, the 30+ years of research and trading conducted by Brandywine since our founding in 1982. During that time Brandywine originated several approaches to managed futures trading and risk management.

In 1991 – at a time when traders were either “fundamental discretionary” or “systematic trend following” – we introduced fundamentally-based systematic trading in our Brandywine Benchmark program. At the same time, we innovated what today has become known as “risk-parity” portfolio modeling. This innovation, which bases portfolio allocation on balancing risk across a portfolio, was documented in a paper that was distributed by Brandywine to investors in the early 1990s. While the rest of the investment world has recently caught on to risk parity, they are still bound by the archaic concept of asset classes.

Brandywine recognized the limitations imposed by the use of asset classes, and so along with its development of risk parity modeling, Brandywine also introduced the concept of “return drivers.” This innovation (the use of return drivers) is discussed throughout Mike Dever’s book, Jackass Investing: Don’t do it. Profit from it., which was published in 2011 and remains an Amazon best-seller.

Brandywine’s Performance

The combination of multiple return driver based trading strategies that incorporate fundamentals in addition to technical factors, risk parity portfolio modeling, and diversification across more than 100 global markets (including financials and commodities), enabled Brandywine to consistently outperform its peers during the 1990s. Brandywine’s Symphony program is continuing this legacy of performance. This is evidenced not only by our positive performance, but by the fact that our current actual performance closely matches our expectations based on our actual past performance and updated testing. If you would like to discuss Brandywine’s investment philosophy, research innovations and performance in more detail, please contact Mike Dever or Rob Proctor, and we will schedule a call to discuss and answer your questions.

Best wishes for a successful New Year.

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Originally published in the Brandywine Asset Management Monthly Report.

Since the launch of Brandywine’s Symphony program in July 2011, the managed futures industry has undergone one of its more difficult performance patches. Over that period the Barclay 50 CTA index has dropped 3.1% and the systematic traders index has suffered a comparable decline. In contrast, Brandywine’s fundamentally-based, yet fully-systematic Symphony program has gained +6.83% and our aggressively-traded Brandywine Symphony Preferred Fund has gained +31.50%.

Brandywine’s positive divergent performance is the result of the diversified, fundamentally-based trading strategies incorporated in our fully-systematic trading model. Developed over the past 30 years, these strategies produce performance that is uncorrelated with traditional CTAs and the major financial indexes. We believe this recent performance, combined with our longevity and past performance, establishes Brandywine as best-of-breed among systematic CTAs and positions Brandywine among the top CTAs for consideration by both institutional and individual investors.

In addition, while Brandywine’s diverse trading strategies result in performance that is uncorrelated to the BTOP 50 during losing periods for the BTOP 50, our model is also able to exploit profit opportunities when market trends reassert themselves. The following two statistics clearly illustrate Brandywine’s favorable performance profile:

Brandywine Symphony’s correlation to BTOP 50 during Peak-to-Trough drawdowns in BTOP 50: -0.11
Brandywine Symphony’s correlation to BTOP 50 during recovery periods in BTOP 50: +0.46

So what the preceding statistics show is that Brandywine’s trading model is able to preserve profits during difficult market environments, such as the one we’ve been in since the start of trading in Brandywine’s Symphony program in July 2011, but also capitalize on market trends when they re-emerge.

Best-of-breed among investment managers is often defined by assets under management. The larger managers are considered better than the smaller managers. After all, they got large because they became accepted by more and larger investors. But larger does not mean better. In fact, as our CEO points out in his best-seller, “Jackass Investing: Don’t do it. Profit from it.,” there are a lot of investment opportunities available to smaller traders that are off-limits, precisely because of their size, to the largest managers. Furthermore, size does not ensure business continuity. In our 30 years of existence, Brandywine has seen the largest managers, through underperformance, become small again, or cease operations altogether.

That said, today the most significant allocations are being made to the largest CTAs. This is not unexpected. The largest investors want to invest in a fashion that is similar to their peers. They are comfortable putting money with the largest CTAs as their decision has been validated, with billions of dollars, by other investors. If their investment loses money, they are at less risk of losing their jobs than if they had invested with a less well-known and smaller manager.

But this is self-defeating behavior. The largest CTAs are fighting a headwind associated with their large size. There are a substantial number of return drivers they cannot exploit because of their size. Brandywine is aware of these limitations. In the 1990s, prior to a shift by our founder towards venture development investing, we were one of the largest CTAs. Our ongoing research at that time was not just focused on finding the best available trading strategies, but the best available trading strategies that could also be traded in substantial size. Since we became a “re-emerging” manager with the launch of our Brandywine Symphony program in July 2011, unencumbered by size, we have been able to re-focus our research effort on expanding our trading across a wide variety of return drivers. The benefit of this diversity shows in our performance.

Brandywine firmly believes that best-of-breed should be defined by the organization and performance. There was a time in the past when Brandywine was considered best-of-breed based partly on our level of assets under management. But even then we stressed that what differentiated us was more than our size; it was our organizational structure, history, investment philosophy and research approach. Those traits continue with Brandywine today and their virtuous effects are manifested in our performance.

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Originally published in the Brandywine Asset Management Monthly Report.

Hurricane Sandy struck at the heart of the U.S. financial markets earlier this week, paralyzing New York City and the venerable New York Stock Exchange. Although “only” a category 1 storm, Sandy cast a wide swath, with tropical storm force winds extending for 1,000 miles. This led to a huge storm surge that wiped out entire shoreline communities in New York, New Jersey and Connecticut. The New York Stock Exchange closed for two days, the first consecutive daily closure due to weather since the “blizzard of 1888.”

Hurricane Sandy over New York City

New York Stock Exchange during the storm

Flooding at the height of the storm

The closure and disruption to financial markets highlighted the need for redundant systems and backup technology to prevent loss of operations caused by natural disasters and other factors. It also pointed out the significance of human factors that could cause business interruptions. The New York Stock Exchange was prepared to open on Monday and remain open throughout the storm, but that would have placed its employees in a dangerous situation. Despite its distributed technology and redundant infrastructure, the actual work of the exchange required people to be present at 11 Wall Street, and the breakdown of transportation and other risks were the primary factor in the decision to close the exchange.

Brandywine understands these risks quite well. Sixteen years ago we moved into our current offices, which are located in a 17th century grist mill in southeastern Pennsylvania (you can see photos of the Mill on brandywine.com). Like all mills, we are situated next to a stream, which for 250 years was used to power the water wheel. Fortunately, we are positioned near the headwaters of the stream, and even in the most severe storms to date (including Hurricanes Floyd, Irene and Sandy) rising waters fell far short of endangering our critical systems. While our operations may not have been directly impacted by a storm, our utility providers have been, resulting in loss of our primary power. Fortunately, we are also able to operate on our backup batteries (which provide uninterrupted power) and generator for extended periods. And we have back-up communications providers that are able to handle our telecommunications requirements in the event our primary phone/internet service fails. These systems serve as our first level of defense against business interruption.

Despite these precautions and redundancies, we are still at risk of a complete loss of our facilities here at the Mill and plan as if that is certain to occur. So as an additional level of backup, we operate a separate, autonomous office in Connecticut. This is staffed by one of Brandywine’s principals, Rob Proctor.

Notwithstanding this preparation and redundancies, we still realize there is a risk of interruption to our business. But in the event that does occur, and as part of our ‘belt-and-suspenders’ approach, all data is backed up daily to the “cloud.” This allows us to recover our business and restart operations as soon as one of our facilities is operational. In that event our loss will be limited to our opportunity costs during the time we were interrupted.

In Brandywine’s 30 years of business we have come to realize that although our primary risk is still related to our trading model and risk management, business continuity is also capable of negatively affecting our clients’ portfolios. Putting in place a sound, redundant infrastructure is an essential element in producing positive returns for our clients.

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Originally published in the Brandywine Asset Management Monthly Report.

Profit opportunities are not spread evenly over time. The key to successful trading is to capture profits when opportunities arise and to protect those profits when opportunities wane. This is illustrated by Brandywine’s historical performance.

The Brandywine Symphony program’s fundamentally-based (yet systematically-applied) trading strategies look for opportunities on a continuous basis. When the program launched in July 2011, many of Brandywine’s sentiment and event-based trading strategies recognized and captured opportunities that resulted from the stock market, currency and interest rate turmoil that dominated the second half of 2011. The result was a 6-month gain of +7.90% for Brandywine’s Symphony and +37.88% for the more aggressively-traded Brandywine Symphony Preferred Fund. This strong performance was especially beneficial to our investors due to the fact that both stock markets and other managed futures traders suffered losses over that same period.

Opportunities for Brandywine’s global trading strategies have been more limited during 2012. But Brandywine has responded well to this environment by preserving the profits earned during 2011. And not only has Brandywine preserved profits, but reduced volatility at the same time. This is exemplified by the fact that our average daily volatility over the past two months has fallen to just 2/3 of our longer-term average. This is also reflected in our decreased trading activity as our trading strategies wait for profit opportunities. (This is another characteristic that separates Brandywine from trend following managed futures traders, which tend to increase their trading frequency during losing periods, as their positions get “whip-sawed.”)

So where does that leave us now? One way to answer this question is to look at the historical tested performance of Brandywine’s Symphony program and estimate when the next set of profit opportunities are likely to appear. One way to measure this is to look at the average length of “quiet periods” such as the one we have been experiencing. Since 1999, the average quiet period has been 168 trading days. The current quiet period is in its 152nd day. While this doesn’t mean that we are on the brink of a new round of profits, it does put the current period in perspective.

A second way to view current opportunity is to compare Brandywine’s actual performance to its target performance. Brandywine’s Symphony program is targeting 12% annualized returns with an 8% annualized standard deviation. After performing above target from July 2011 through February of this year, the 3 month drawdown in March – May brought the performance to 7% below trendline. This is now in line with the 7.5% average of the 12 largest underperforming periods over the 12 year test period starting in 1999.

Brandywine’s aggressively-traded Symphony Preferred Fund targets returns and risk that are between 3x and 5x that of our standard Symphony program. As illustrated in the chart below, the Fund has performed below target since April. While we must state that PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE, research indicates that our current drawdown is once again entering the range in which to expect a rally.

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Originally published in the Brandywine Asset Management Monthly Report.

Every investor is aware of the disclaimer that “PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE.” It is mandated by regulators to be written on all materials that contain performance information. At its basic level what this means is that you (and the people with whom you’re investing) CANNOT predict the future. Evidence of this abounds. As people have learned, just because John Paulson produced billions in profits from 2007-2010, that didn’t mean he’d produce the same result – or even profit at all – in 2011 or 2012. A primary reason for this unpredictability is that many investment managers and traders follow a singular or concentrated investment process or thesis. When that process or thesis is correct they profit. When it’s not, they suffer losses. They are not truly diversified.

Some people go so far as to interpret this observed unpredictability to mean that it is futile to try to pick winning investments. This belief has manifested itself in the drive for people to simply buy an index. But that action itself is based on the belief that the index will continue to perform in the future in a fashion consistent with how it performed in the past. The reality is that every decision is based on a prediction. As Mike Dever shows in his best-selling book Jackass Investing: Don’t do it. Profit from it., no investment performs in the future simply because that’s how it has performed in the past. For example, in his opening chapter, which you can read here, he shows that there is no magical “intrinsic” return for owning stocks. Every potential investment is based on at least one sound, logical “Return Driver.” The key to understanding future performance is in understanding the validity of the underlying return drivers.

While understanding the return driver underlying a trading strategy will provide an indication of the validity of that trading strategy, it will not provide an indication of the predictability of future returns relative to past performance. That is because any one return driver, no matter how valid historically, can become invalid as a result of changing circumstances. For example, prior to the introduction of the Euro, many traders employed convergence strategies based on the fact that other European currencies were soon to be replaced by the Euro. That strategy obviously became invalidated when the Euro came into existence. This is an example of a “transient” trading strategy. Transient strategies abound. When the U.S. Federal Reserve commits to holding interest rates low, traders can profit from the strategy of borrowing short and buying long, taking advantage of a “locked-in” yield curve. When the Swiss National Bank pegs the Swiss franc to the Euro, traders can employ reversion strategies in the belief that any deviation from that level will result in the rate reverting back to 1.2 CHF to the EUR (although an argument can be made for a conflicting transient strategy, that of buying CHF in expectation that Swiss National Bank resolve will ultimately wane, and when they ‘give up’ the peg, the value of the franc will then rise sharply against the Euro).

There is a way, however, to improve the probability that future performance will approximate past performance. That is to employ numerous trading strategies that are both:

• unrelated and
• sustainable

This is the approach used by Brandywine.

Brandywine employs dozens of individual trading strategies, based on unrelated and sustainable return drivers, to trade across more than 100 global commodity and financial markets. Supported by our actual trading of many of these strategies in the 1990s, and our extensive back-tested results both prior to and after that period, we have confidence in the validity of the return drivers underlying each of the trading strategies. Although any given trading strategy may produce a somewhat volatile return stream, we have a high level of confidence the character of that return stream is repeatable.
For example, the chart below displays the back-tested results of one of Brandywine’s sentiment-based trading strategies. Because we are displaying back-tested results, 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 SUBSEQUENTLY 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.

This strategy is based on a sound, logical return driver. When investor sentiment in individual global stock markets reaches extreme lows, usually as a result of a rapid sell-off, Brandywine looks to buy if prices fail to extend to new lows. The chart shows the back-tested performance of this strategy assuming a constant position size and no compounding of returns. Over the 21½ year period profits totaled $1.3 million (based on $500,000 allocated by Brandywine’s Symphony program to this strategy, which provides Brandywine with our targeted 12% annualized return). Over the test period the strategy proved to be a strong performer, with a nicely sloping uptrend in cumulative profits. Since the start of actual trading in Brandywine’s Symphony program in July 2011 (evidenced by the vertical line in the chart below, which is an extension of the prior chart), this performance has continued.

But as pleased as we are with the past performance (both tested and actual) of this strategy, and as confident as we are in its sustainability, we realize there have been, and will again be, hostile environments that will result in losses for this strategy. While we expect this strategy to profitably contribute to the long-term returns of Brandywine’s Symphony program, we are totally uncomfortable projecting its shorter-term performance. Also, as good as this past performance looks, if we were trading this strategy on a standalone basis, note that it would have suffered a $353,000 loss (on the $500,000 allocated to the strategy) from April 2000 through January 2002.

However, this drawdown only poses a problem if this strategy is viewed in isolation or used as the only strategy in a portfolio. Adding additional trading strategies, each based on a different sound, logical return driver, reduces the probability that the portfolio as a whole will face an adverse environment. For example, the chart below shows the tested past performance of one of Brandywine’s event-driven strategies. This strategy trades interest rates based on inflation factors and reports. As the chart illustrates, with inflation seemingly in check throughout the 2000s, this strategy was presented with very few trading/profit opportunities. But during the same period during which the previously-displayed strategy produced its $353,000 drawdown, this strategy produced a significant profit, gaining $340,000 from April 2000 through January 2002.

Because the two trading strategies shown above are based on disparate return drivers, the correlation of their returns is zero. As a result, by simply combining the two trading strategies shown above, we can create a portfolio with performance that is better, and more predictable, than either of the strategies alone.

This is the simple premise on which Brandywine’s Symphony program is built. By combining dozens of independent trading strategies, which each produces profits and losses independent of the others, Brandywine’s Symphony program is able to earn the average return of each, while dramatically reducing drawdown and, here’s the most important benefit, increasing the probability that our future performance will match our past performance. This is because Brandywine is not dependent on any single market environment or condition to produce profits. Instead, our overall performance is the result of the combination of hundreds of strategy-market performances, each one of which is based on its own distinct return driver, independent of the others.

While the concept of true portfolio diversification is simple, its execution is not. Brandywines’ Symphony program is the culmination of more than 30 years of research and trading by Brandywine. We pioneered the use of fundamentally-based trading strategies in a 100% systematic portfolio. Perhaps most important, is the method Brandywine developed to allocate capital across its trading strategies and markets. Unlike most portfolio modeling formulas, which are designed to produce the best risk-adjusted results, Brandywine developed a portfolio allocation model with the primary goal of producing predictable performance. The effectiveness of this approach is evident in our results, where our actual performance continues to perform in line with both our past actual and tested performance.

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