World Beta Blog

I don’t know how CXO does it, I really don’t. They consistently churn out great reviews of cutting edge academic papers. In a recent review, CXO takes a look at a Andrew Lo paper titled, Financial Econometrics.

An interesting aside, here is the book(s) that forever altered Lo’s college career choice towards economics. [Lots of former scientists, myself included, have done the "reverse Samuelson"]:

Paul Samuelson’s research also led him to take a dim view of portfolio managers. Samuelson (1974) stated that “a respect for the evidence compels me to incline toward the hypothesis that most portfolio managers should go out of business-take up plumbing, teach Greek, or help produce the annual GDP by serving as corporate executives.”

The series is also featured heavily in the book, The Predictors, about quant hedge fund The Prediction Company.

One institutional service that aggregates quant research in working papers is the apt named Alpha Letters. I took their free trial for a spin, and it is definitely recommended if you can get corporate to pay for it. . .

It has been slightly more than 5 months since I started my blogging experiment, and today is officially my 100th post! (It certainly feels much longer than that.) It is a bit surreal to be in a London cafe right now, having just polished off some of the best dim sum I have ever had after watching my first cricket game this morning. It has certainly been a useful endeavor from my perspective – getting emails and questions from all over the world has spawned quite a few fertile areas of research. Stay tuned for some much needed upgrades to the site in the current months.

The Battle of the Quants turned out to be a stellar conference (get those visions of nerds smashing calculators and stabbing each other with sharp pencils out of your head, this was a civil ‘Battle’). A little groggy from sleeping in the JFK airport, and minus one laptop that fried itself on the flight over, I made it through the day with the help of some strong coffee and English tea. A couple notes below.

The most pleasant surprise was the keynote speech by Nassim Taleb, author of ‘Fooled by Randomness’ and ‘The Black Swan’. I enjoyed Fooled by Randomness, but struggled to get through The Black Swan, and skimmed most of it. (I always struggle with books that could be 20 pages long that slog on for 300.) The talk, however, was highly entertaining, and painted an entirely different picture of Taleb than I gathered from his books (namely, an intellectual oozing with pretense). Taleb has started a new company, Universa, that is the follow on to Empirica. (And I believe it has > $1B in commitments.)

Two interesting notes from the talk. 1 – Taleb stated that 97% of his lifetime P&L occurred on one day (you guessed it, 1987). His product seems much less of a ‘hedge fund’ than a insurance type product. 2 – He mentioned how ironic it was that Gauss’s picture used to be on the Dutsche Mark 10 Bill, replete with the normal distribution in the background. Gauss did not invent the normal distribution (Abraham de Moivre did), and could there be a worse example of a normal distribution than the hyperinflation that plagued the German currency?

The second part I wanted to mention was the obligatory ‘Hedge Fund Replication Technique’ panel. I have blogged numerous times on the topic before, and have even penned an article on the subject. I just don’t get the appeal when you can match the returns with a simple buy and hold of world asset classes.

I am here until the weekend attending the IRC Asset Allocation Summit, and if my laptop is working I will send updates from the conference.

Any Brits have any good advice for the rest of my trip?

Finally

If you live or work in London, drop me a line. I am in town for a couple of speaking engagements.

Battle of the Quants, June 14
IRC Asset Allocation Summit, June 18-22

If anyone is attending either conference, please introduce yourself!

Based on the Technorati and Alexa rankings.

The full article can be found here.

Q: Could you give us some specific pointers as to how you do that [focus on the long term]?

A: Absolutely. We feel that there are four distinct, albeit inter-related, issues that long-term investors need to take into account – and they’re what we think of when constructing and managing the Harvard portfolio. They’re factors we believe will play out in the market for several years to come.

First, it’s important to have a diversified and internationalized portfolio. For the average investor, this may mean shifting part of the domestic equity exposure into international equities and introducing some commodities. We believe that long-term global forces are in play. For example, we’re looking for a growth slow-down in the United States. Yet emerging economies, as well as Japan and Europe, are experiencing higher growth.

Commodities also serve as great diversifiers, and they provide some downside protection against a geo-political shock emanating in the Middle East. A good idea is to purchase a diversified commodities mutual fund or an ETF (exchange-traded commodities fund).

Second, within domestic equity exposures, we’re looking for a handoff from small-cap and mid-cap to larger-cap companies. This has to do with the growing influence of the private equity. We believe that large cap companies will be next to benefit from the large influx of private equity capital buying up companies. Private equity companies are now targeting larger capitalization companies. As an example, think of the recent news on Cerberus Capital Management, the private equity firm, buying Chrysler for some $7 billion.

Third, it’s a good idea to have some inflation protection in the portfolio. The world has benefited in the last few years from two major dis-inflationary forces that will likely diminish in importance going forward: increased U.S. productivity and the entry of low cost workers in the global workforce, particularly in China and India.

As these forces diminish, inflationary pressures will pick up, making securities such as TIPs (Treasury Inflation-Protected securities) a good addition to portfolios. The fourth theme may distant to the average investor, but it’s of enormous importance. Suddenly more central banks in the world will be reconsidering how to deploy their capital. The numbers are large. For example, China has over $1 trillion of reserves, Russia over $250 billion and Brazil over $120 billion. To date, most of these funds have been invested in U.S. bonds, and Treasurys in particular. Over time, they’ll adjust the allocations to other parts of the world.

I am not sure why I didn’t think about this before, but below is a table with hedged versions of the Hedge Fund Best Ideas Portfolio. The L/S version is 50% hedged, rebalanced yearly. The Market Neutral version is 100% hedged, rebalanced yearly. I repeated the portfolio with both S&P and Russell 2000 Indices as hedge choices. I did not make any concessions for short rebates. Sharpe is at 4%.

The first chart is the spread between corporate bonds and 3-Month T-Bills. The second chart is the spread between emerging market bonds and U.S. Three possible plays on tight credit spreads would be to buy AFBIX, or to short LQD or HYG.

Turning your back to all of the available information can lead to false conclusions. . .

When it comes to selecting stock factors, I am admittedly agnostic. I constantly remind myself to let the data speak for itself, all while layering in a bit of common sense. I resist the urge to label myself a value guy, or momentum guy. (Or even a high asset turnover declining short interest guy.) That being said, both a trendfollowing and value approach make sense to me, and contrary to popular belief, are not mutually exclusive.

(Speaking of trendfollowing, after posting back to back double-digit negative years – and a -25% start to 2007 – Merrill Lynch is pulling ~ $600M from the John Henry funds, ending an 11-year relationship. Time to buy some RYMFX?)

There are truckloads of academic evidence supporting both the momentum and value approaches, and I am not going to do a lengthy review here. CXO reviews a paper from a couple years back titled, “The 52-Week High and Momentum Investing“. Simply put, buying new highs works. A great paper by the guys at Blackstar also confirms this hypothesis – “Does Trendfollowing Work on Stocks?“. (My favorite part about the Blackstar approach is that it is backed up with empirical evidence that resembles a real world trading system including delisted stocks and volatility based risk management.)

Below is some quick-and-dirty evidence since 1987. Column 1 is S&P500 return, Column 2 is the top 50 stocks ranked by price/52-week high (near or at highs), and Column 3 is the bottom 50 stocks ranked by price/52-week high (stocks near 52-week lows). Only companies >$100M market cap were included, and the portfolio rebalances yearly.

The site I used is backtest.org, and is great for simple queries using the Value Line database (which if I remember correctly, is about 2000 stocks).

I examined the hedge fund best ideas portfolio to query if the funds were buying stocks near their highs or lows. Of the 20 stocks listed, the average distance from the 52-week high was 6.44%, and the median was 2.73%. the results are skewed due to the large distance away from highs for USG (46%) and BSG (23%). Most of the other 18 stocks are at or near 52-week highs. Depending on the index, the average stock is somewhere between 10 – 30% from the 52-week high.

It looks like the hedge funds are buying stocks that are going up (or the stocks are going up because the hedge funds have been buying them).

I also decided to input the Hedge Fund Best Ideas portfolio into the Morningstar X-Ray software to see what the composite portfolio looked like. Below are the stats for the portfolio, followed by the ratio relative to the S&P500:

Price/Earning Forward: 21.47, 1.35
Price/Book Ratio: 2.70, 1.00
ROA: 6.87, .62
ROE: 16.67, .84
Projected EPS Growth: 19.37, 1.7
Yield %: .68, .42
Average Market Cap: $24B, .45

It sure seems like the value hedge funds are finding more “value” in growth stocks right now. . .

A slightly different indicator is a chart courtesy of DecisionPoint.com charting the historical trend of S&P500 stocks relative to their 52-week RANGE. I imagine it correlates highly with average % from Hi and % of stocks above the 50-Day SMA.

Here is a link to the original PDF, “Strategic Asset Allocation and Commodities“, and also to the Q&A with Bob Greer from PIMCO.

Put your thinking cap on – I am still undecided about a few of the conclusions in the paper. . .

(Bolding below is mine).

Q: And what did Ibbotson conclude regarding the optimal size of an allocation to commodities going forward?

Greer: As I mentioned previously, Ibbotson projected future commodity returns using three different methods: the capital asset pricing model, the building-blocks method and a combination of the first two methods.

The optimal allocation to commodities varied depending on the method. At the 10% standard deviation level—a moderate risk level similar to a standard portfolio of 60% stocks and 40% bonds—the optimal allocation to commodities ranged from about 22% using the capital asset pricing model to as large as 28.9% using the building-blocks method. Even at the conservative 5% risk level, optimal allocations to commodities were relatively large, ranging from about 9% up to nearly 14%.

Regardless of the method used in projecting future commodity returns, portfolios that included commodities in the opportunity set were also more efficient than those that excluded commodities, based on the Sharpe Ratio.