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!

Currency Wars and the Future of Money

Davide Accomazzo

email: davide@cervinocapital.com

When in 1992 Francis Fukuyama published his best-seller “The End of History and the Last Man,” he made the case that the success of Western Liberal Democracy was going to sign the end of man’s evolution toward its final form of government and so mark the end of history.

The book made me chuckle then and even more today while not only can’t we agree on a final form of social organization but we can’t even agree on a global payment system.  The remaining and now most pressing legacy of the 2008 global financial crisis seems to be the determination of the future for the International Monetary System (IMS) or in layman terms the way we trade and pay each other globally.

Historically, every major financial and social crisis ended with a re-designing of the IMS; WWI marked the end of the first wave of globalization and virtually ended the pure global gold standard which was forever abandoned after the Great Depression; at the end of WWII, the Bretton Woods agreement established the US Dollar as the global reserve currency and the only currency convertible into gold.  This convertibility ended amidst the stagflation crisis of the 1970 when Nixon closed the conversion window in 1971.

Here we are, forty years later, staring down the abyss hoping for a global flash of ingenuity and a new mantra to fix a badly imbalanced monetary system.

So what went wrong? 

During the Bretton Woods agreement, J. M. Keynes advocated the creation of a global currency, the Bancor, to be utilized to settle all international trade.  The Bancor would also have required the creation of a global Clearing Union which would have managed the inevitable trade surpluses and deficits among nations. The Union would have implemented rules to curb such imbalances and hopefully pushed the system toward more equilibrium.  Ironically but understandably, the US opposed such view and successfully lobbied for the Dollar to virtually become THE global currency.  I suppose winning a global war while retaining intact all of your production facilities and storing most of the available reserves of gold would give you such a negotiation advantage…

Being the provider of the global currency allowed the US great financial benefits, at least for a few years.  The constant demand for Dollars to settle international trade lowered the US cost of financing and allowed for larger trade and fiscal deficits that would have been possible otherwise.  Another by-product of this position was to practically impose globally our monetary policy; as John Connally, Secretary of the Treasury during the Nixon administration, famously said to a delegation of European politicians: “The Dollar is our currency but your problem.” 

Or is it?

In light of today’s crisis we may rephrase: the Dollar is our currency and everybody’s problem.  The initial advantage, I referred earlier, to run larger deficits thanks to the currency role as a global reserve unit, lead to the Triffin Dilemma.  Trifflin warned that a country providing the global reserve currency would have had eventually an incentive in running TOO large deficits and then inflate its way out them.  A perhaps unforeseen element a few years ago might have also accelerated the process; not only the US was incentivized to run large trade deficits but many emerging markets decided to marry their fortunes to the “produce-at-the-lowest-cost-and-export” model and heavily manipulated their currency vis-à-vis the dollar to achieve trade advantages.  Systemic and chronic imbalances were created. 

We are now locked into an unsustainable global position where the large exporting countries feel they cannot succeed without a constantly undervalued currency, the US will eventually inflate its way out of trouble and virtually all players will engage in some form or another of currency wars. The high stakes poker game is on.

While short term solutions vary from allowing for a faster appreciation of the Chinese Renminbi (China running the largest trade surplus) to a diversification of global reserves from just the USD to include other currencies, the question remains on what kind of system we can agree globally that might, in the long term, be more stable than the present one. 

A nostalgic fringe has been calling for a restoration of the gold standard but this is impractical for a number of reasons.  A pure gold standard tends to be deflationary (albeit proponents of this solution might actually find this a plus) and probably would not really end mercantilist policies.  The present geographical distribution of the metal would also pose logistical and political problems during the transition to the new system.  A not so pure gold standard based on paper claims or other types of derivatives would eventually end up manipulated just as our current currency system. [1]  Yet gold does have certain characteristics that might help finessing the system.  It has been accepted globally for thousand of years as a store of value and a medium of exchange; it is finite, it does not decay, it is malleable.  And its price responds to perceived instability and global inflationary pressures.

If gold is not the answer then is a global currency, just like Keynes advocated seventy years ago, a workable and likable solution?  Possible but with a number of precautions.  Common currencies are complicated affairs; think of the Euro and its disconnect between the monetary union it represents and the fiscal disunion that characterizes it.  A common currency requires to some degree a loss of sovereign power; another famous macroeconomic dilemma or better “trilemma” highlights the three major objectives a government will want to achieve while only able to achieve two of them:

-         an open current account

-         stable currency

-         domestically oriented monetary policy.

In other words, a global currency will require some sort of supranational oversight in terms of trade policy, like limiting surpluses and monetary/fiscal policy in order to avoid inflationary temptations. 

Robert Zoellick, President of the World Bank, has recently called for a mixed system of different major currencies, including a liberalized Renminbi and gold as an international reference point for global monetary policy.  The details are vague and it is unclear which entity would enforce the given parameters; in fact it is unclear whether any country would trade domestically oriented monetary policy for FX stability.

Will we need another crisis to force us into a disciplined approach?

Contact details: davide@cervinocapital.com 

Sources:

Robert Zoellick, The G20 must look beyond Bretton Woods II, Financial Times, November 7, 2010

International Monetary Fund, Reserve Accumulation and International Monetary Stability, April 13, 2010

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[1] Disclaimer: as a money manager I trade a gold based strategy.