World Beta Blog

One can only hope that this is the beginning of a trend. GLRE started trading this week.

Blake Grossman [Barclays], “The markets are very efficient, very dynamic, constantly reaching greater levels of efficiency that makes them more and more difficult to beat. The half-lives of our strategies are shrinking”

Bob Litterman [Goldman], “I am not worried that markets are fully efficient – yet. But they are becoming more efficient all the time, and fast. The world is going quant, and there are not secrets! Alpha is in limited supply and hard to find.”

Myron Scholes, “We are one group among myriad teams making markets more efficient by compressing time.”

It’s the Covariance Stupid!

There is a great discussion of some asset allocation topics in Bernstein’s new book, “Capital Ideas Evolving”. (However, the first half of the book I skimmed). In the chapter profiling the Yale Endowment:

Swensen describes the process this way: “Mean/variance was a powerful influence in causing us to move away from the standard institutional portfolio. You never get a recommendation of 65% equities from mean/variance – it’s always telling you to move toward diversifying asset classes that promise equity like returns. These kinds of results led us to emphasize private equity and venture capital, real estate, hedge funds offering long/short or absolute return strategies, and investments in raw materials like timber.”

…Along the way, Swensen has been faithful to one of Harry Markowitz’s favorite observations about asset allocation: “It’s not the variance you have to worry about, it’s the covariance.” In other words, you can hold plenty of risky assets with high expected returns as long as they fluctuate independently rather than in step with each other.

Here is an example. Below is a table for a standard 60/40 allocation since 1972 (S&P500 and 10 Yr US Govt Bonds). Following Swensen’s lead, we reduce the stock and bond exposure by 20% each, and add two riskier (more than double the volatility of bonds) asset classes at 20% each – REITs and commodities. Notice how the return improved and the risk declined, all due to the assets being uncorrelated. We then take 40% off the original stock position, and distribute it to REITs and commodities evenly at 20% (S&P / Bonds / REITs / Commodities).

What would an Endowment Portfolio formed from publicly traded vehicles look like? I have written extensively on the endowment method of investing before. Below I list 10 world betas followed by the alternative holdings. The percent weightings are in the ballpark of the Harvard and Yale endowments. Only one fund is foreign listed (the private equity portion), because there is no US equivalent (I don’t like PSP). Consequently, one could use any of the myriad foreign listed funds of funds as well (Goldman, Dexion, Alternative, etc.).

There are lots of ways one could tweak this portfolio . ie using leveraged ETFs to port alpha from the alternative funds, etc. . .

I would like to hear your comments on the allocation. . .

While idolized in music lyrics, fat tails are to be avoiding in trading systems and investment funds.

There is typically little crossover in the hip-hop and country music genres. Trace Adkins made the leap when he penned his chart topping song, “Honky Tonk Badonadonk” in 2005.

“We don’t care bout the drinkin’
Barely listen to the band
Our hands, they start a shakin’
When she gets the urge to dance
Drivin’ everybody crazy
You think you fell in love
Boys, you better keep your distance
You can look but you can’t touch
That honkey tonk badonkadonk”

According to Wikipedia, the term (which is slang that refers to a woman’s particularly large buttocks) had originated with rapper Keith Murray in 2001, then sent into the limelight with Missy Elliot’s hit “Work It” in 2002. It has gone on to be featured in such mainstream programs as Crank Yankers, Late Night With Conan O’Brien, and Subway commercials.

The term for “fat tails” in finance is kurtosis. Wikipedia describes as the “measure of the peakededness of the probability distribution”. The first and second moments of a statistical distribution, mean and variance (or standard deviation), are typically sufficient to describe the characteristics of a distribution – and consequently, the returns of a hedge fund or trading strategy. However, skew and kurtosis can add more color to the analysis, especially when the distribution is not normal.

Research performed over the past 50 years has shown that market price changes do not follow a normal distribution, and Maubossin provides a good overview of this property and its implications in “A Tail of Two Worlds“. Mark Shore’s paper, “Skewing Your Diversification“, also presents a wonderful review of asymmetrical asset class returns, as well as a thorough lesson on understanding and applying the higher statistical moments of a distribution such as skewness and kurtosis. Malkiel and Saha (Hedge Funds: Risk and Return) present an interesting discussion of hedge fund returns and their asymmetric characteristics. I have not read “The Black Swan” by Taleb, in which he examines the influence of highly improbable and unpredictable events that have massive impact, but it has received good reviews.

Higher kurtosis (fatter tails) means more of the variance is due to infrequent extreme deviations. A distribution with positive kurtosis is called leptokurtotic. In terms of shape, a leptokurtic distribution has a more acute “peak” around the mean (that is, a higher probability than a normally distributed variable of values near the mean) and “fat tails” (that is, a higher probability than a normally distributed variable of extreme values).

When selecting funds, or designing trading systems, effective risk management depends on differentiating between the different types of volatility, and the acceptable amount of ‘tail risk’. (Mark Shore describes volatility as being like cholesterol, it comes in good and bad variations. Upside volatility is not necessarily bad, but downside volatility is to be avoided).

A good example of a strategy with high kurtosis would be option selling funds. They consistently make high monthly returns until there is a price or volatility shock, and then can have extreme downside losses. I touched on the topic in an earlier post – “Are Option Selling Funds a Blowup Waiting to Happen?”. LTCM is really the poster child for tail risk.

In a recent post over on the excellent blog All About Alpha, there exists a good discussion of kurtosis. William Shadwick, founder of the London based quant group Omega Advisors, posts a primer on tail risk analysis. He introduces a new statistic titled the “C-S Character”, to correct for the shortcomings of the kurtosis measure, which he describes as wildly volatile. I have not delved into the details, but on first glance the post and paper are very intriguing.

Two new reads I have on the way look like “Market Wizards for Quants”. A third is a new book by Ralph Vince:

The Handbook of Portfolio Mathematics by Ralph Vince
How I Became A Quant bu Richard Lindsey
Derivatives Models on Models by Espen Haug

You can choose more than one, and if your favorite isn’t listed, type it in “Other”.

Others listed:

* Fairholme
* Brightline Capital
* Tuckerbrook Long/Short Value
* Kiefer Total Return Growth Fund
* kinetics
* Fir Tree
* Arcadia Value Partners
* Landmark Select Fund
* RGM Capital
* Lansdowne partners
* Krom River
* Arcadia Capital
* LaGrange Capital Partners
* egerton
* Sturgeon
* Centaurus Capital
* Farallon Capital Management (2)

Jim Simons

A good article in Forbes magazine this month:

Surfin’ ETFs

I have discussed various cross-market momentum strategies on the blog in the past, and you can view two below:

Simple Cross Market Momentum
Cross-Market Momentum Follow Up (with link to the COP Strategy)

The Forbes article features a strategy by Robert Colby. He ranks 200 ETFs on 6-month momentum, and forms portfolios of the top 10. The article mentions that he rebalances frequently, but does not say how often. This simple strategy is backed by solid academic evidence, although I admit using 200 ETFs is probably overkill due to high correlation and overlap. 50 or so should be sufficient. One of the problems with using so many asset classes is that the portfolio could be heavily concentrated in one general asset class. Reviewing the table in the article, all ten holdings are foreign markets.

I would be curious if Colby uses any of the leveraged or inverse funds. Below is a sample list of 10 and then 50 ETFs one could use in a ranking system:

10 ETFs

50 ETFs

Wow, I sure would like to be invested in Bruce Sherman’s Private Capital. Two of his top three holdings are AT (getting bought by TPG/Goldman for $71.50) and MGM (up 30% today on talks with Tracinda). From the Stockpickr description:

“Bruce S. Sherman is Chief Executive Officer and Chief Investment Officer of Private Capital Management. He has led investment research and portfolio management activities since founding the firm in 1986. Sherman has been featured in the book Investment Gurus by Peter Tanous. Sherman’s investment philosophy and money management approach are rooted in a basic value approach to buying stocks. It has worked out well as he has returned an astounding 20% annually since starting his fund.”

PCM’s Investment Approach is a Four Step Process (From the website)

Step 1. Screening thousands of publicly traded companies each year to identify the potential for significant value that is currently unrecognized by the stock market.

Step 2. Confirming undiscovered value through rigorous financial analysis, focusing on “discretionary cash flow.”

Step 3. Learning all we can first-hand about the quality of management.

Step 4. Capturing the undiscovered value for our investors.

AT is a Hedge Fund Best Ideas Holding, and anyone tracking the strategy could sell it and replace it with Sherman’s next biggest holding, HPQ. (We make the substitution in the tracking portfolio at the close today.) Alternatively, one could hold it until the deal closing near year end 2007 for an approximate 3.6% premium.

You can view the rest of his holdings here:

HT
CA
HPQ
MGM
BSC
HET
SYMC
LEH
EK
FCE
VRSN
BEAS
GCI
JW
BYD
UHS
RJF
IGT
WIN
BLC

Our family used to vacation at a beach house on Topsail Island N.C. Edward Teach, aka Edward Drummond, aka Blackbeard, was rumored to frequent the area (he lived in Bath, N.C), and the Wiki entry speaks to the history of its name:

“Topsail Island is supposedly derived from its nefarious history. According to popular belief, pirates once hid in the channel between the island and the mainland waiting for passing ships. The topsail was supposedly the only part of the pirate ship that could be seen by the passing ‘victim’ until it gave chase. There is a legend that Blackbeard hid his treasure on Topsail Island and it is still being searched for today.”

Visions of searching for hidden treasure and pieces of eight filled our vacations there. I spent many a day combing the beach for signs of doubloons, but the closest I came was finding loads of sharks teeth – I and can remember filling up entire mason jars full of them (not so comforting when you’re swimming).

While dreams of becoming a treasure hunter have faded over the years (insert astronaut, NFL quarterback, etc) I remember reading an article a few years back in some magazine regarding “dream jobs”. One such job was treasure hunter, and the profile was Mel Fisher. Mel Fisher passed away in 1998, but was the architect of the largest treasure find ever – the Spanish galleon Nuestra Senora de Atocha, which sank in a hurricane off the Florida Keys in 1622. Fisher found it in 1985, and retrieved a reported $400M in coins and other booty. Still have the treasure hunting itch? The operation is still ongoing, and you can download their diver application here. Some more background here:

Bounty of the Deep
The Billion Dollar Boat
and a book on the search, “Fatal Treasure”
and a DVD on the search, “Treasure! The Search for the Atocha”

What does any of this have to do with investing? Explorers from Odyssey Marine Exploration (publicly traded OMR) announced today that they have found what could be the richest shipwreck treasure in history – 17 tons of colonial era silver and gold coins worth an estimated $500M. Article here. This news has catapulted the stock from its closing price yesterday of $4.60 to $7.21, for a 50%+ return.

Interestingly enough, a number of hedge funds own the stock, including DE Shaw, Fortress, Goldman Sachs, and the apt named Galleon. . .I’m off to San Francisco for the weekend for the annual Bay to Breakers “race”. . .have a great weekend to all!

Now that the 13Fs have been filed with the SEC, it is time to update the Hedge Consensus, Activist Consensus, and Hedge Fund Best Ideas Portfolios. Background on this post can be found in these links:

Let Seth Klarman Manage Your Portfolio
Cloning the Buffett Portfolio
Constructing a Best Ideas Hedge FOF
Show Me Your Hand – Greenlight

Below is commentary on the YTD performance as well as new portfolio holdings:

12/31/2006 – 5/16/2007

(Note: The Best Ideas strategy was initiated after the beginning of the year, & the performance may not have been similar do to possibly different holdings. However, Goldman estimates the top holdings of hedge funds only experience ~ 20% turnover, so the results should be fairly close. The similar performance (with different holdings) of the two hedge fund strategies lends some comfort here.)

The best ideas portfolio makes the most sense to me. It selects each hedge funds best ideas, and also allows the investor to maintain a constant number of holdings. The consensus strategy could have a variable number of holdings. The concept of consensus implies crowding to me, but if I were to follow it, I would likely use the Combo strategy, as that increases the number of funds to 25, and underlying holdings up to 400+ stocks.

New Portfolios
(New holdings are in bold, sold positions in italics after the portfolio)

Activist Consensus
BBI
BGP
DADE
HD
KSU
SHLM
THX
TLM
TNS
TWX
UNM
YHOO

HLT
LCAPA
LGND
LINTA
MCD
MSFT
PDLI
SYMC
TWC
WLT
WMB

Hedge Fund Consensus
AMX
AXP
BRK
FD
GOOG
MSFT
QCOM
WMT

AAPL
AMT
CMCSK
FDC
TYC
UNH
WU

(and the double repeats are below as well)
AAPL
AMP
ASD
BEAS
BIDU
CF
CMCSK
CROX
CSCO
CVS
ESRX
FLML
HRZ
MA
MDC
MLM
SAI
SINA
TV
TXT
USG
UNP
UNH
WLP
WU
YHOO

Hedge Fund Best Ideas
AMP
AMT
AMX
AT
BAM
BNI
BSG
CA
CVS
DISCA
GOOG
HLX
MSFT
PHG
QCOM
SCHW
SLM
UFS
USG
WMT

AXP
CVA
DEO
ETN
FDC
IBM
KO
MLS
NWS-A
OSIP

COMBO (Includes all the hedge and activist funds)
AXP
BRK
CVS
DADE
FD
GOOG
HD
MLM
MSFT
QCOM
UNM
WMT
WU
YHOO