Sunday, August 6, 2006

July 2006 Review and the China Factor


We are pleased to report that our Diversified Option Strategy program returned a positive 1.47% for the month of July 2006, resulting in a year-to-date return of 5.50% and continuing seven straight months of positive performance. This is in comparison to the S&P 500 Index (GSPC) which returned 0.51% for July and 2.28% for the year; meanwhile, the Barclay CTA Index, as of this writing, is down 1.26% for July and up only 1.45% for the year.

Most of our July gains in the Diversified Option Strategy program came from our quant-oriented positions in expiring S&P contracts, and a fundamentally based position in natural gas. Increased volatility overall has helped us achieve higher returns in the past couple months just as at the beginning of the year our monthly numbers were slightly depressed by the lack of volatility. For more information, please visit our website at

During the month some interesting macro economic numbers were released; in particular, those relating to the Chinese economy were the most attention-grabbing. For the second quarter 2006 China’s gross domestic product (GDP) grew 11.3 percent over the year earlier, while industrial output clocked in at a record 19.5 percent rate in June. At the same time investment and exports have catapulted China’s economy to the world’s fourth largest in the 28 years since free-market reforms began. It is worthy to note that the China boom is hurtling along at its fastest pace since 1994 when its economy was one-fourth its current size.

The situation in China reflects a global economic landscape that has undergone a seismic shift in the last decade, and is echoed by the fact that the combined economies of China and India are now greater than the United States. According to the Bank of Nova Scotia emerging and newly industrialized Asian nations, excluding Japan, now account for 30 percent of the world’s economic growth when GDP is adjusted to reflect purchasing power parity. Meanwhile, the countries that make up the G7 (Canada, France, Germany, Italy, Japan, Britain and the United States) currently represent 41 percent of global GDP, down 6 percent from a decade ago.

Asia’s ascendance as an economic superpower has been augmented by robust regional dynamics. Trade within the Asian region centered around China is now nearly twice as large as the trade that takes place within the NAFTA zone. As a result of the boom, infrastructure projects in the area are undergoing a massive expansion, and the furious pace has spurred a migration of people from the country to cities and led to rapidly rising income levels, which has in turn boosted consumer spending.

The problem is that this level of growth in China is not sustainable as it leads to rampant inflation, inefficiencies in capital allocation, margin compression and increased banking instability. The Chinese government recognizes this and has embarked on a series of steps to try and rebalance the economy. These steps include an increase in the banks’ reserve requirements, a cut in tax rebates from exports, tighter controls on land development and a range of other “administrative measures.” However, while there are signs these actions are starting to have some impact, most are far from optimal.

Administrative measures are blunt instruments that create distortions elsewhere in the economy. They are also hard to enforce. It is reported that the majority of recent land transactions in some provinces are illegal because local governments have defied Beijing’s directives to restrain property investment. By the time orders do get implemented, there is a risk that it will be too little too late. In the meantime, a belated increase in interest rates is widely expected soon, although such increase is unlikely to rise by enough to restore neutrality. As a result, monetary policy is set to remain over-stimulative for the time-being.

In their defense, China’s central bank’s caution to use monetary policy may partly be because the effectiveness of such tools in China’s economy is limited. But that point reveals a central issue—that China is NOT YET a mature free market country, and in fact has a primitive financial system which is still centralized and steered by politicians who act primarily to benefit their political interests first.

Given decisions to date China’s policymakers are more concerned with denting growth. China needs GDP growth north of 7% a year just to stay even with its massive population and new job seekers. Reducing unemployment and underemployment requires even faster growth. At the same time, the government is alarmed by runaway real estate prices because unaffordable housing has become a major political flashpoint for the majority of urban Chinese.

This poses a real conundrum for the Chinese government. As long as China is fueled by cheap money, slowing down one sector through “administrative measures” only means that the money will flow into other sectors and create an asset bubble somewhere else. In any case, at this point Beijing is for now reluctant to effectively tackle the growing domestic imbalances in its economy by implementing “modern” fiscal and monetary policies.

With that in mind we can attempt, by looking at the interests of the political elite, to make an educated guess as to the timing of when China may be forced to face the ramifications of its extreme growth.

In two years China will host the largest international event: the 2008 Olympics. This will be the perfect showcase for the new China, a country which knows well that for the first time in its modern history it has an opportunity to position itself as a global economic and political superpower. As it stands the idea that American hegemony is overstretched and fatigued represents thinking advocated/ believed by many, Russia’s economy under its “oily curtain” is too reliant on the vagaries of international commodities markets, India remains the acknowledged tortoise in the economic race between the two Asian giants, while "old" Europe–too busy figuring out the meaning of life–shuffles from one crisis of confidence to another.

So until 2008, notwithstanding any uncontrollable economic tsunami occurring, China will continue to aggressively build up its infrastructure and secure more raw materials and energy supplies at any cost whatsoever. This factor has already been evident in the magnitude of increased demand many commodity markets have already experienced. If China follows this script then Chinese economic growth and supply-side demand will be prolonged for at least the next two years. Therefore, as a general trading framework, we should look to take advantage of any short term technical weakness in commodities, keeping in mind the summer of 2008.

What about after the 2008 Olympics? I think China (and the world) will have to come face-to-face with its enormous portfolio of non-performing loans which will cripple China’s banking system. The ramifications are potentially scary when one thinks about the fact that China is the second biggest holder of U.S. Treasuries and together with Japan accounts for more than half of world reserve accumulation between 2002 and 2005. In fact, the United States now needs to attract about $2.5 billion a day to fund the trade gap and keep the value of the dollar steady.

The build up of reserves and a growing trade deficit with China has given U.S. politicians fodder to demand change. The U.S. has been pushing China to let its currency trade more in line with market forces. Fed Chairman Ben Bernanke also chimed in saying “I don’t think that we can continue to finance the current account deficit at 6 percent or 7 percent of GDP indefinitely, and it’s desirable for us to bring down that ratio over a period of time.”

Yet others argue that the squeals in Washington at the yawning U.S. trade deficit with China are overblown. The basis for the viewpoint is that the wide difference between both sides’ data is overstated. After ironing out data discrepancies, Oxford Economics found that China’s share has hovered at about a fifth of the total U.S. merchandise deficit since 1995. By most measures, the U.S. is still the top manufacturing nation producing almost a quarter of global output, the same as in 1994. If U.S. manufacturing is stronger than many Americans believe, China poses a weaker challenge than is often supposed as its output is still less than half that of the U.S. and many of its industries are suffering a severe profits squeeze. According to the Institute for International Economics and the Center for Strategic and International Studies, on average two-thirds of the value of Chinese products is imported. Further many big-ticket Chinese exports are of things no longer made in the U.S. or that have never been made here. Therefore a large renminbi revaluation would merely shift Chinese production to lower-cost locations elsewhere.

When push comes to shove, the recent tumult in the middle-east and the resulting “flight-to-quality” into U.S. Treasuries reminds us that for the time-being the greenback’s status is still “the” world currency reserve. And when all is said and done, those who would fear China imposing a new economic world order should think back to when the same was said of Japan.

However things evolve economically and/or politically, the Chinese proverb “may you live in interesting times” seems appropriate at this juncture in our world’s history.

- Davide Accomazzo, Managing Director

Tuesday, August 1, 2006

Relative Performance vs. Absolute Returns

"And so instead of absolute places and motions, we use relative ones; and that without any inconvenience in common affairs; but in philosophical disquisitions, we ought to abstract from our senses, and consider things themselves, distinct from what are only sensible measures of them." invest in cervino capital management invest in cervino capital management invest - Isaac Newton, 1687

It seems simple but knowing whether a portfolio manager is doing a good job can be a challenge. It's difficult to define what good is because it depends on how the rest of the market is performing. For example, in a bull market 2% is a horrible return. But in a bear market, when investors are down 20%, just preserving your capital would be considered a triumph. In that case 2% doesn't look so bad.

Absolute return is the fixed percent an asset or portfolio returned over a certain period. Therefore, the 2% mentioned in the paragraph above is considered absolute return. If a mutual fund returned 8% last year, then that 8% would be its absolute return.

Relative return, on the other hand, is the difference between the absolute return and the performance of the market (or other similar investments), which is gauged by a benchmark or index such as the S&P 500. Relative return is the reason why a 2% return is bad in a bull market and good in a bear market. For example, if the absolute return of your portfolio is 10% and the performance of the S&P 500 during the same time period is 6%, then you have a relative return of 4% greater than the market (10% - 6% = 4%). If, however, during this same time period the S&P 500 returns 15%, then you have a relative return of -5% (10% - 15% = -5%).

Why is relative return so important? Because it is the generally accepted method for measuring the performance of actively managed portfolios, which should get a return greater than that of the market. After all, you can just buy an index fund that has a low management expense ratio and will proxy the market’s return. However, if you’re paying a portfolio manager to perform better than the market and the investment doesn’t have a positive relative return, it may be worth finding a new manager or just buying an index fund.

But this is where it can get complicated. Who is to say what the “market” is? The S&P 500 index is often cited as the benchmark for the U.S. stock market but in actuality it represents mostly large capitalization stocks. The Russell 2000 serves as a benchmark for small-cap stocks in the United States, while the Lehman Aggregate Bond Index is comprised of fixed income securities to simulate the universe of bonds in the market. Relative return can also be used within a context smaller than the entire market. For example, a technology fund's performance could be measured or benchmarked against other technology funds. What about foreign stock markets? Have you heard of the FTSE, DAX, Nikkei, or All Ordinaries? These benchmarks represent stock indices for London, German, Japanese and Australian equities, respectively.

It’s wise to look at relative return to see how an investment's return compares to other similar investments. The trick is finding a comparable benchmark in which to measure your investment's return; then make a decision of whether your investment is doing well or poorly. That said, in the final analysis, the power of compounding is best accomplished with consistent positive returns year-in/year-out regardless of market conditions. Investors re-learned this fact after the 2000-2002 bear market, and this is why so many institutional investors have substantially increased their allocations to absolute return programs.

Realizing that traditional methodologies may not be sufficient in helping achieve investment goals leads to the problem of finding absolute return strategies. In order to accomplish this sophisticated investors have increasingly embraced a new paradigm that rejects total return as the measure of a strategy's worth. The concept is that any strategy's total return can be divided into a market return (beta) and 'ideally' a net excess return (alpha). What is of real value is an investment strategy's ability to consistently generate alpha.

The bottom line is it is not easy to find strategies that consistently generate risk-adjusted excess returns. For example, investors must be able to distingish market returns (beta) from excess returns resulting from skill-based actions ("true" alpha) and excess returns resulting from non-skill-based actions (e.g., consistently holding large cash positions, taking increased benchmark risk, or using leverage). Even when one is knowledgable about these performance evaluation concepts, the investor must have access to alternative investment managers (many have high minimums and require "accredited investor" status), be comfortable with the structure, and after making an investment, monitor existing managers to ensure their approach continues to provide desired alpha.

The greatest barrier to acceptance for this investment approach is often psychosocial: the unwillingness to try something new based on frequently cited "conventional wisdom" that is marketed by an industry riddled with conflicts of interest, not to mention regulators and regulations that end up institutionalizing "good" from "bad" investment approaches. The herd mentality always tends to rule. Luckily, innovative investment strategies, such as those offered by the regulated approach called managed futures or unregulated vehicles known as hedge funds, are increasingly becoming accepted as a desirable means for diversification. (In the opinion of this author, hedge funds should be regulated but not the investment strategies they promote.)

The move to the new paradigm of alternative investments, absolute returns, separation and recombination of beta and alpha requires that investors think differently about the investment process and their investment portfolio. No one is claiming that investors should rush to embrace this new paradigm. Instead, they should carefully evaluate this shift to determine its benefits and risks. This understanding will alow investors to develop a prudent plan so they can properly respond to new opportunities.

In conclusion, the separation and recombination of beta and alpha is only one of the fundamental principles of the new investment paradigm. The other, the acceptance of alpha-based strategies as a part of an investor's asset allocation policy is equally important. The search for alpha is difficult, especially when the source of alpha is the asset class itself, such as with managed futures. The key objective for investors is to distinguish manager skill from market returns and factor in investment management costs; that is, pay minimal fees for beta, and only pay for uncorrelated alpha.

The Diversified Option Strategy of Cervino Capital Management is an example of an absolute return program where returns are derived primarily from skill-based trading decisions. While past performance is not necessarily indicative of future results, the program has been able to sustain consistent positive monthly performance since inception as well as very low correlation when compared to the S&P 500 index. Positions are diversified across various financial and commodity markets, and entail complex option strategies that have varying degrees of market direction exposure: long, short or neutral. A key part of this strategy is recognizing that options are a wasting asset. Accordingly, the trading model is similar to the insurance business model whereby premiums are collected and risk management is the primary focus. For more information, visit

- Mack Frankfurter, Managing Director