World Beta Blog

Quite of few of my emails have ended up in the Spam folder so if you sent something and didn’t hear a response please fire another one over.

—-

I love going home to my father’s house in CO as he has a whole library of books I left behind.  Flipping through the old Bill Gross book “Everything You’ve Heard About Investing Is Wrong! : How to Profit in the Coming Post-Bull Markets”

In a related take on the “New Normal”, Montier’s new must read: “In Defense of the Old Always“.

—-

A Contrarian’s Guide to Football Betting (WSJ).

—-

Top hedge fund stories 2010 (AR)

—-

Another must read, Howard Mark’s “All That Glitters“:

In 1952, Noah S. “Soggy” Sweat, Jr., a member of the Texas House of Representatives, was asked about his position on whiskey. Here’s how he answered:

“If you mean whiskey, the devil’s brew, the poison scourge, the bloody monster that defiles innocence, dethrones reason, destroys the home, creates misery and poverty, yea, literally takes the bread from the mouths of little children; if you mean that evil drink that topples Christian men and women from the pinnacles of righteous and gracious living into the bottomless pit of degradation, shame, despair, helplessness, and hopelessness, then, my friend, I am opposed to it with every fiber of my being.

However, if by whiskey you mean the oil of conversation, the philosophic wine, the elixir of life, the ale that is consumed when good fellows get together, that puts a song in their hearts and the warm glow of contentment in their eyes; if you mean Christmas cheer, the stimulating sip that puts a little spring in the step of an elderly gentleman on a frosty morning; if you mean that drink that enables man to magnify his joy, and to forget life’s great tragedies and heartbreaks and sorrow; if you mean that drink the sale of which pours into Texas treasuries untold millions of dollars each year, that provides tender care for our little crippled children, our blind, our deaf, our dumb, our pitifully aged and infirm, to build the finest highways, hospitals, universities, and community colleges in this nation, then my friend, I am absolutely, unequivocally in favor of it.

This is my position, and as always, I refuse to compromise on matters of principle.”

Sweat’s response shows, depending on how you look at it, either how views can diverge on a given subject or how differently a tale can be spun. Thus it serves well to introduce the topic of this memo: gold.

DIVERSIONS

Chances are that you’ve been to a restaurant and had your food cooked by the sous vide method of cooking.  Since Cuisinart hasn’t put out a cheap model yet (and the SousVide Supreme is still about $300) I tried some steak and chicken through the budget “beer cooler and thermometer method“.  Great results!  Even Thomas Keller has a cookbook dedicated to the subject – Under Pressure: Cooking Sous Vide.

Although that pales in comparison to former MSFT CIO (CTO?) Myhrvold’s 2400 page, $500 (and $1mm production cost) Modernist Cuisine: The Art and Science of Cooking.

—-

While I have yet to book a hotel on Jetsetter, it is a weekly drop by for some killer deals on some of the top hotels in the world.

Finally added Thaler’s Nudge blog to the blogroll.  Interesting post on The Charity Deduction.

—-

You need to be different and make concentrated bets if you’re an active manager, and Morningstar has a way to find the closet indexers.

—-

Ebert’s top movies of the year.

—-

A fun read about inflation.

—-

A nice piece from the NYTimes on activist funds and ValueAct specifically.  Following their picks on a quarterly basis on AlphaClone would’ve beaten the market by over 15% a year since 2002:

In our last post we took at look at two forces that are lining up for a potential strong year end and start to 2011 (particularly in small/micro caps) and other beaten down shares.

One other area that may be ripe for a bounce is the closed-end muni funds.  If you believe that the January Effect is due to tax-loss selling by retail investors combined with window dressing portfolios (and who wants to show they own muni funds after this big downleg?) then munis could be set up for a nice boune.  The bond king has been even putting his own cash to work lately.

The website CEFConnect is a good resource for investors screening for closed-end funds.

Here is a nice white paper on the topic:  Tax Loss Selling and the January Effect:  Evidence From Municipal Bond Closed-End Funds

ABSTRACT

Below is an example of what might be covered in the upcoming launch of our monthly newsletter.  If you haven’t done so, sign up here!

Any trading system that uncovers alpha must have a justification for why the strategy works.  If you cannot explain why the inefficiency exists then you are likely just data mining and exposing your portfolio to unintended risks with uncertain outcomes.  Ray Dalio, Founder of the world’s largest hedge fund Bridgewater Associates states

“Because I believe that all criteria for investing (that is, good betting strategies) should have a logic that isn’t time specific, I believe that the alpha generators that make up the ultimate alpha generator should be timeless and universal. By that I mean that they should have worked over very long time horizons and in all countries’ markets.”

There are countless strategies, indicators, and systems that are mentioned in the popular press with such catchy names as The January Indicator, Dogs of the Dow, Elliot Wave theory, Dow Theory, Sell in May and Go Away, and The Fed Model.  As a responsible investor that is risking hard earned cash when investing, it is of utmost importance to validate any indicator or system of investing (and yes I include buy and hold based on Modern Portfolio Theory here too!).  Even with reams of supporting data it is vital to step back, employ some common sense, and ask why a tendency (because some are just that, tendencies) may work.

Two such anomalies are setting up for a favorable year end and start to 2011.  The first is what is known as the Presidential Cycle.   This theory goes that equity returns during the third and fourth years of a President’s term are more favorable than the first two years.  The fundamental justification  is that the President tries to force any difficult legislation into law during the first two years of his presidency.  Historically the President’s political party loses power in the midterm elections (as we saw this past November).  After the first two years, the task of re-election takes hold and the President is consumed with securing a second term of office or campaigning for his party’s potential replacement.   The data bear out that monetary and fiscal policy have historically been easiest during these periods as the President moves the machinery of the Federal Government in order to promote economic growth and lower unemployment.

The historical data support this theory – -there are even studies that go back to the early 1800s (although data are a bit spotty pre-1900).  Median returns have been 5% in Year 1, 5% in Year 2, 22% in Year 3 and 11% in Year 4 since 1927.    Since World War II the S&P 500 has not had a down Year 3 at all with gains averaging 18% per annum.  The fourth quarter of Year 2 (the one we are in now ending December 31, 2010) is the best performing quarter followed by Q1 and Q2 of Year 3 (January – June 2011).  Can you be certain that Year 3 will be positive?  No, of course not as evidenced by the awful 1931 bear that lost 44%.  Some critics of this approach argue that the recent stimulus of the past two years front loaded and distorted any potential ramp in 2011 and 2012.  But there are reasons to believe that more often than not it will be.

A second market bias is the large outperformance of small cap stocks in January.  Historically small caps outperformed large caps in 80% of all Januaries by 3 percentage points per year (small caps being defined as the bottom 30% of stocks market cap weighted).  So-called microcaps (the smallest of the small caps) historically produce even better results.  The fundamental reason for this tendency is tax sensitive investors (mostly individual retail investors) sell small caps to lock in year-end tax losses, then reinvest their portfolio in the New Year.  An academic paper by Haug and Hirshey called “The January Effect”, examines this property all the way back to 1800 with supporting results.

Some analysts have argued that the January Effect has moved into December as investors look to front run this tendency.  This is a classic example of traders adjusting to market inefficiencies and an example of their behavior having a direct influence on market inefficiencies.

What about combining of these two factors, The January Effect in small caps and the Presidential Cycle?  Historically across the 48 months in the four year cycle the January of Year 3 is the single biggest outperformer with median returns since 1927 of nearly 8% a month for small caps.  Does this mean that January is guaranteed to be great?  Again, nothing is guaranteed – Year 3 Januaries have varied from 27% to down 10%.  While many of these tendencies are just that, investors can view them as head or tailwinds that could give bulls and bears pause.  The easiest method to take advantage of this effect is to go long a small or microcap ETF (IWC, PZI) or mutual fund (BRSIX).  For a more market neutral approach, go long a microcap ETF and short a large cap ETF (VTI, SPY).  Derivatives such as options could also be used to gain cheap exposure while limiting downside losses.

Research has also shown that screening for small caps down significantly from their highs in mid-December respond the best to the January Effect.  A simple screen could include stocks trading above a minimum market capitalization (say, $30mm) and below a level considered small or microcap ($100 to $300mm).  The smaller the stocks the higher the risk as well as the higher the potential reward.  Two sample screens are below courtesy of the Ned Davis Stock Screener ($ required) but one could use any of the dozens of stock screeners that are free or paid (like Portfolio123).  Other potential fields to add could be insider buying and fundamental factors including earnings, etc. :

Small (Market Cap > $50mm & < $300mm, down at least 70% from the 52-Week High)

Tiny (Market Cap > $10mm & < $120mm, down at least 60% from the 52-Week High)

(Note: You must sign up through the email list to receive the monthly newsletter via email…)

We are starting a monthly newsletter that focuses on longer form analysis somewhere between the breezy style of the blog and the much longer white papers.  I already have a list of about 20 studies I would like to publish but have yet to for a number of reasons.

Each newsletter will likely feature a main topic/research piece along with a few other constant monthly features (like Reading List / What I’m Reading, Asset Class Review, Alternatives Review).  The content will evolve as we get more feedback on what interests the readers the most and some months will be much shorter than others depending.

The first issue will be out in a week so make sure to sign up through the email list to receive it!

A few ideas we have for longer form research pieces:

Update Quant Approach to TAA and Relative Strength Strategies for Investing with data through 2009 and 2010

Fundamental Factors and Building an Econometric Model

Where the Black Swans Hide

Quant Approach to Dow Theory

Guru Allocations and Timing

Trendfollowing on Currencies

Returns of Asset Classes during inflation, Fed policy, yield curves, etc

Global Asset Allocation Funds

And more (any in particular you would like to see email in suggestions)

Interesting piece in The New Yorker by Cassidy What Good is Wall St?

There is a particularly interesting section on Woolley and his Centre for the Study of Capital Market Dysfunctionality.  Linked is a speech he gave and his 10 point manifesto for investing (I think #4 is particularly interesting ):

The heart of the presentation is a 10 point memorandum targeted at what he calls giant funds, the custodians of social wealth, which he defines as sovereign funds, corporate and public pension funds and university foundations and endowments. Woolley’s thesis is that these giant funds have become unwittingly complicit in the creation of a vast unstable monster that the global financial system has become.

1  Adopt long-term investment approach (future dividend flows), rather than momentum (short-run price change)

2  Cap annual turnover of portfolios at 30%

3  Understand that all tools now used to manage risk and return are based on the discredited theory of efficient markets

4  Adopt a stable benchmark such as growth of GDP plus a risk premium

5  Not pay performance fees

6  Not engage in alternative investments – Hedge funds, Private equity, Commodities

7  Insist on total transparency of agents’ strategies

8  Ensure everything in the portfolio is traded on a public exchange

9  Secure full transparency of banking service costs incurred by companies you invest in

10  Provide full disclosure of compliance with these policies

Not sure why they would do this as an ETN (well, I understand their arguments but they don’t hold water to me) but interesting to see the continued progress of alternative beta funds launching:  RBS US Large Cap Trendpilot Exchange Traded Note

In realated news it looks like Greenblatt has been busy launching his magic formula as mutual funds, FNSAX and FVVAX etc  (though the only difference I see is the number of holdings?).  They have filings for international and global funds as well…bummer to me to see that they have done it the conventional mutual fund route with all the associated fees and share classes but congrats to them on the continued strong AUM raise.

In my book The Ivy Portfolio we touched on three hedge funds that we thought made sense to follow their long stock picks.  We presented hypothetical results for following their top 10 holdings updated quarterly from 2000-2008.  It is nice to see that those three funds (Blue Ridge, Greenlight, Berkshire) on average have outperformed the S&P500 by about 3.5% per year since publication in real time (2009 – 12/2010).

All data courtesy AlphaClone.

Later in the chapter I included a list of 54 funds that I thought would be interesting funds to follow.  Out of that 54, 8 were never added to the database and 4 have since ceased operations.

Excluding the dead and never added, the other 42 funds beat the S&P 500 by an average amount of 13 percentage points per year.

Even if you included a super conservative -20% return per year for the dead funds the group would have averaged an over 8 percentage points per year outperformance.

Roughly 70% of the funds beat the S&P500 over the time period.  Impressive real time results!

The best performing fund from my short list was Pabrai up over 300% and the worst was Tontine who was flat.  Mohnish’s clone is up a whopping 60% YTD with top holdings including POT, HNR, BPO, CRESV, and ATSG.

We already have one blog reader that has won the NAAIM prize for best paper, let’s get another!  Deadline is March 2011 and the prize is $10k.

—-

I have long believed there is an opportunity for online education surrounding investing and personal finance.  A few different sites have investing/finance as a component of their offerings (like Sympoz and MIT Open Course) but I have yet to see the “Rosetta Stone” of investing education.

—-

I actually didn’t know FQ took over a mutual fund as sub until a reader left a comment on the blog.

Here is an older PDF “Balancing Betas“.

Managers FQ Global Essentials Fund (MMAVX)

—-

Great post on just how little people understand about investing.  Wow.  From the Dorsey Wright folks:

“If interest rates rise, what will typically happen to bond prices?

18% - They will rise
28% - They will fall
5%   -They will stay the same
10% - There is no relationship between bond prices and the interest rate
37% - Don’t know
2%  - Prefer not to say

The heinous data above comes from Finra’s newly released Financial Capability Survey: only 28% of the national sample of more than 28,000 adults had a clue that bond prices would fall if interest rates went up.  This strikes me as a pretty good argument to get a competent financial advisor.

In unrelated news, 67% of respondents rated their overall financial knowledge as “high,” and 75% endorsed the statement, “I am pretty good at math.”

The financial market is a really expensive place to get an education.”

—-

Diversification and Risk Management.

—-

Many investing blogs and websites exist for the purposes of investor education, and many are professionals that are supposed to have a fiduciary duty to their clients.  If you write an investment blog or run an investment website and also run Google Ads such as the below on your site I can’t take you seriously.  It’s embarrassing.

81% Profit in 1 Hour – Every Hour!

What are today’s top 3 hot stocks? Top 3 penny stocks gaining fast.

Up 1,381% since inception

I read everything from GMO so a bit surprised I didn’t see this:  Momentum – A Contrarian Case for Following the Herd