The Inefficient Market Advantage

Davide Accomazzo

Email: davide@cervinocapital.com

For decades Wall Street has pushed forward an investment agenda based on the academic research initiated in the 1960’s by Prof. Markowitz, the now notorious Market Portfolio Theory (MPT) and the Efficient Frontier.

While the historical investment context in which MPT  developed was indeed lacking some sort of scientific support to analyze risk and performances, the answer provided by the theory – mean-variance optimized portfolios – ended up overlooking the real fabric of the markets and therefore failing investors once the going got tough.

Markets are not efficient because market participants – much to the chagrin of MPT followers - are not fully rational agents.  But more sadly, markets are inefficient also because of massive asymmetrical information and manipulation of markets structure by better positioned economic agents.

So if markets are not efficient, how do we take advantage of anomalies and more importantly how do we protect our portfolios from those frequent and damaging grey and black swans?

Of course there is not one answer; the proper approach is a function of the individual investor’s resources, interest, risk profile and time.  An interesting portfolio management approach that is sophisticated yet relatively simple and low maintenance is the “Core-Satellite” construction.

In its most simplistic form, an investor would allocate a larger percentage of his/her funds to a beta replication instrument like a passively managed index ETF or a mix of subsectors ETFs (the core).  This portion of the portfolio would be beta driven but also cost-effective from an implementation point of view; there will be no high management fees, almost inexistent transaction/slippage costs and low taxes.  The satellite (a smaller percentage of the total of the portfolio) would be dedicated to alpha seeking strategies or in other words skill based, uncorrelated investment programs.  This portion would be actively managed, priced accordingly and with an uncorrelated and/or higher expected rate of return.

In today’s environment of generally low rates of returns across all traditional asset classes and with beta having largely disappointed all investors, a more complex approach to core-satellite is due.  I like to create a core that is low cost and essentially multi-beta driven with an additional embedded risk management mechanism in place and a satellite that is truly defined by superior skills and that can possibly lower my systematic risk.

Years ago I came across a study by Mebane Faber[1] that utilized the 10 month moving average as a buy/sell filter for a portfolio of 5 major asset classes: Domestic Equities, International Equities, Real Estate, Commodities and Bonds.  This approach works very well and easily for the construction of a cost efficient, multi-beta driven yet actively managed core.  Based on the data of the study, the risk adjusted combined results were quite attractive.

Utilizing ETFs, the investor can tailor a multi-beta core at low cost by choosing different subsectors (from more traditional strategic allocations to more refined and personalized ones) and utilize the 10 month moving average as the risk filter that will liquidate any segment of the core that falls below the moving average.

The satellite could then be built by investing in skill based, uncorrelated to the core strategies like managed futures.  Managed Futures, usually structured as Commodity Trading Advisors (CTA), operate strategies based on futures and options in diversified global markets such as commodities, market indexes, interest rates and metals.  Including a precious metal strategy in your satellite should also help lower the systematic risk of the overall portfolio since gold is estimated to be a zero-beta asset with generally no covariance with traditional asset classes.

In conclusion, the difficult and often dislocating investment environment of these past ten years is probably going to continue; the investment universe is hardly as rational and prone to exact modeling as MPT leads to believe. The world is messy and a more pro-active approach is needed to build portfolios that can withstand the stress of our times.

Contact details:

davide@cervinocapital.com

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[1] Mebane Faber, “A Quantitative Approach to Tactical Asset Allocation” Journal of Wealth Management 2007

The 10 Essential Investment Rules

Davide Accomazzo

Email: davide@cervinocapital.com

At the end of 14 grueling weeks in my Portfolio Management class at Pepperdine University, I wrap it up with this 10 rule list.  After all the fancy formulas and complex graphs we review in class, the art of investing comes down to common sense and risk management. After my many years in the trenches, managing money for investors from all over the world in multiple and very different markets, I can confidently say that these 10 rules are your lifeline.

1. Understand the nature of expected returns.

One of the keys to a long and successful investing career is to truly understand the nature of the expected returns; in other words WHY should this particular investment or strategy produce a positive return, what are the drivers of price formation, what is the investment thesis supporting our decision and are past circumstances going to have the same weight in the future?

2. Fully understand the risk

Understanding the reasons for expected returns is only half the story; you must also understand the risk associated with the investment. You must run a stress test and identify what contingencies could develop and how your investment would perform in those situations.  Do not rely on static historical correlations but adopt a correlation scenario approach where you allow for specific disruptions to occur.

3. Analyze performance on a risk adjusted basis

Looking at performance numbers in a vacuum is meaningless and yet incredibly common; you must always put performance into the context of risk; do not assume that higher performance numbers are the result of superior management; is it superior investment selection (or superior timing) or just leveraged beta?  

     4. Risk management is the most important element of investing

This is by far THE MOST IMPORTANT rule of all.  Finding investments is easy, entering trades is easy…controlling the risk is hard.  Never allow for a loss to be terminal to your account; always have an exit strategy BEFORE you enter the trade. A classic market truism says: “Good traders know how to make money, great traders know how to take a loss.”

                       

      5. Discipline overrides conviction

Investing is a probability game; if you can be disciplined and follow a process based on rules 1 and 2 AND you constantly control the risk so that a loss will never take you out of the game, you will succeed in the art of investing.  Never be emotionally involved, never “marry” a position and…never take it personally when things don’t work out. 

6. Adapt your style to changing market conditions (market structure changes)

Rule 6 may sound contradictory to rule 5 but in fact it is complementary.  You must be disciplined but you must also have a review process that alerts you when “structural” changes happen in the market which may require you to adapt.

     7. Opportunities are made up more easily than losses

When in doubt…pass. Over 40 markets are open every day for business, opportunities abound. Losses are practically and emotionally tough to make back.

    8. Emotions are your worst enemy

Treat investing/trading as a job; have a process, have risk management and if you are looking for a thrill go to Vegas or take on paragliding. Investing should be boring and not emotionally charged.

    9. Act independently of the crowd (but do not be a contrarian just for the sake of it)

Being a sheep does not produce consistent superior returns in the investment universe. However, you must have a process to identify out of the box ideas and to identify peaks of complacency or fear among the crowd so that you can take the other side of the trade. In other words be creative but do not be a contrarian just for the sake of it.

  10. Perception is reality.

As Gordon Gekko eloquently said 25 years ago: perception is reality when you invest. Remember that as an investor you are making a guess of what the average investors’ guess is of an uncertain future outcome.

Good luck!