Sunday, April 10, 2011

1st Qtr 2011 Review and Black Swan Events


Starting in 2011 we envisioned more bi-directional trading along with increased volatility given the backdrop of rising oil prices. This prognostication came true when a spike of volatility hit the equity market as a result of the earthquake in Japan. Nevertheless, the spike was short-lived, and the resilience of the equity market allowed for only a brief respite before returning to prior highs. The result was one of the best quarters on record for stocks.

Long only strategies are still faring better than expected and finding alpha by looking to arbitrage relative values has proven difficult. The S&P 500 seem to be grossly overbought technically and not so cheap fundamentally, but the positive breadth and strength shown in the face of even nuclear misery indicates a continuation of a positive bias for at least the next 2 or 3 months. The second half of the year, on the other hand, could prove trickier as interest rates seem pointing higher. One reason is that QE2 ends in June. As a result insider selling is on the pick up.

The nuclear disaster in Japan, while heartbreaking from a human and emotional angle, might have improved the long term fundamentals of natural gas, LNG and coal. Many of the MLPs in our portfolio are actively engaged in those spaces and we are looking to increase our exposure to those specific names in an opportunistic way. On the subject of Master Limited Partnerships, their spread over the 10 year UST is now fairly narrow and makes this asset class a little less attractive in general. Corrections would be welcome and should be used to pick up better yields.

The unfortunate events in Japan not only changed the fundamentals of natural gas but we think they created the conditions for a long term bear market in the Yen. After the Kobe earthquake, the Yen spiked briefly and then embarked in a multi year correction. We think the current situation sets up some interesting investment opportunities. At the same time, we have also reduced our exposure to short duration TIPs which performed up to the present much better than long duration but now are showing signs of topping. And then there is gold…

The yellow metal did have a bout of volatility with a severe correction in the first few days of the year followed by a strong rally and now churning action. We feel that gold should continue to churn for the next few months as negative seasonality kicks in and the big gains of the second half of last year are digested. It is important to continue to monitor various central bankers around the world to get a sense of how real their determination to fight inflation is. I think words are cheap and actions are constrained by the reality they helped construct. After the seasonal pause, gold should resume it higher trend. In commodities, we also continue to like crude oil and are in the process to launching a CTA program similar to our strategy in gold to capture what we expect to be a persistent uptrend for the next few years.

--Davide Accomazzo, Managing Director
(Written March 31, 2011)

Managed Futures: Is It an Asset Class?

For those unfamiliar with the term managed futures, it is a niche sector of alternative investments that evolved out of the Commodity Futures Trading Commission Act of 1974, and refers to professionally managed assets in the commodity and financial futures markets. Management is facilitated by either Commodity Trading Advisors (CTAs) or Commodity Pool Operators (CPOs) who are regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA).

Managed futures is the little kid brother to the hedge fund juggernaut. Even so, its impact upon the industry is writ large in two significant and related ways: first, managed futures unlike its brethren hedge funds operate in a highly regulated environment; second, this same regulated environment which imposes disclosure and reporting requirements lends itself to fomenting lower barriers of entry for new talent to evolve. Interestingly, the institutionalization of alternative investments can be traced back to the development of managed futures performance tracking databases first established around 1979. This data became the basis for an academic body of research on managed futures beginning with the seminal study by Harvard Business School professor, Dr. John E. Lintner.

So is managed futures an asset class? Let’s cut to the chase… in this writer’s humble opinion the answer is no, absolutely not. Well, maybe we would reconsider if managed futures was confined to just commodity interests, but with futures contracts also trading on financials, managed futures is as much an asset class as are registered investment advisers, mutual funds or hedge funds.

Lee, Malek, Nash and Rose (2006), on the other hand, would beg to differ. Their paper The Beta of Managed Futures makes the case that the predominant strategy in this space is trend following, and thus an appropriate benchmark for managed futures is one that mechanically mimics trend following systems. To say the least, it’s an interesting approach, and one which addresses issues related to peer group analysis and indices based on a composite of individual CTA programs. As Lee, Malek, Nash and Rose posit, “CTA indices represent the result of investing in CTAs, not the results of investing like CTAs.”

The weak part of their thesis, however, has to do with the assumption that managed futures essentially represents just trend following strategies. Lee, Malek, Nash and Rose readily admit that CTAs “employ a wide range of methods” and that such methods are “by no means exhaustive,” and include “breakout systems, systems based on moving averages and systems based on pattern recognition”. They attempt to reconcile this issue by creating a “beta benchmark” that “consists of twenty systems trading the world’s most liquid… markets”. According to their study, they found that their benchmark, for the period analyzed, was highly correlated to large CTAs.

That said, a mechanical trading index approach still leaves questions, including the validity of the trading methods utilized and the robustness of the parameters used to supposedly define the “beta of managed futures”. At a more subtle level, questions are raised by a relatively new concept proposed by Lo (2004) called the Adaptive Markets Hypothesis (AMH). AMH is based on an evolutionary approach to economic interactions and builds on the research of Wilson (1975), Lo (1999) and Farmer (2002) in applying the principles of competition, reproduction and natural selection.

In light of AMH, the paper by Lawrence Harris, The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity provides an intellectually honest answer as to the true dynamics underlying managed futures.

The following is from the paper’s abstract; written in 1993, it is not something you’d likely see in an academic paper nowadays: “Trading is a zero-sum game when measured relative to underlying fundamental values. No trader can profit without another trader losing. People trade because they obtain external benefits from trading… Three groups of stylized characteristic traders are examined. Winning traders trade for profit. Utilitarian traders trade because their external benefits of trading are greater than their losses. Futile traders expect to profit but for a variety of reasons their expectation are not realized.”

Harris goes on to discuss the obvious but little acknowledged fact that, “Trading performance reflects a combination of skill and luck. Successful traders may be skilled traders or simply lucky unskilled traders. Likewise, unsuccessful traders may be unskilled traders or unlucky skilled traders... We would like to believe that skill accounts for most variation in past performance among traders and managers,” but “from past performance alone, you cannot confidently determine who is skilled and who is lucky.” Therein lies the conundrum and the alternative investment industry's dirty little secret.

From this 20,000 foot level, the paper drills down and “examines the economics that determine who wins and who loses when trading.” Harris considers “the styles of value-motivated traders, inside informed traders, headline traders, event study traders, dealers, market-makers, specialists, scalpers, day traders, upstairs position traders, block facilitators, market data monitors, electronic proprietary traders, quote-matchers, front-runners, technical traders, chartists, momentum traders, contrarians, pure arbitrageurs, statistical arbitrageurs, pairs traders, risk arbitrageurs, bluffers, ‘pure’ traders, noise traders, hedgers, uninformed investors, indexers, pseudo-informed traders, fledglings and gamblers.” The paper goes on to “describe each of these traders, explain how their trading generates profits or losses, and consider how they affect price efficiency and liquidity.”

Because this paper was written in the early 1990s some of the descriptions may admittedly be dated relative to technological and quantitative developments in the field of trading since. Nevertheless, Winner and Losers of the Zero-Sum Game is a little noticed gem of a working paper whose astute observations ring true even today despite the escalating arms race in academic working papers being spun out of the university-industry revolving door.

Then why is managed futures constantly referred to as an asset class? Answer: out of laziness. However, such laziness goes beyond just the financial industry’s responsibility; truth is, half the problem lies with investors themselves—try as one might to delineate sophisticated investment concepts, the most common reaction is investors’ eyes glazing over.

So if managed futures is not an asset class, then what is it? As with many of the acronyms and lingo that the financial industry regularly comes up with, mainly for marketing reasons, the term has become a misnomer. What started out as an investment activity that was defined by regulations is now conventionally considered by many an asset class. C'est la vie

- Mack Frankfurter, Managing Director

Winners and Losers of the Zero-Sum Game - Harris

Harris, Lawrence. “The Winners and Losers of the Zero-Sum Game: The Origins of Trading Profits, Price Efficiency and Market Liquidity” School of Business Administration, University of Southern California, Draft 0.911, May 7, 1993.

Lee, Timothy C.; Malek, Marc H.; Nash, Jeffrey T.; and Rose, Jeffrey M. “The Beta of Managed Futures,” Conquest Capital Group LLC, February 2006.

Lintner, John E. “The Potential Role of Managed Commodity—Financial Futures Accounts (and/or Funds) in Portfolios of Stocks and Bonds” Presented at the Annual Conference of the Financial Analysts Federation, May 1983.

Lo, Andrew W. “The Adaptive Markets Hypothesis; Market efficiency from an evolutionary perspective” The Journal of Portfolio Management, 30th Anniversary Issue 2004, pp. 15-29.

Sunday, January 9, 2011

2010 Year End Thoughts and Economic Politics


As we close the curtains on 2010 with positive performances across all of our strategies, we search for new themes and new opportunities to exploit in 2011.

The past two years, in the aftermath of the most devastating financial crisis since the Great Depression, have witnessed a strong politicization of the economic process with encompassing ramifications in most investment models. The liquidity flood of 2009 and collapsed volatility reignited one-directional trades in equities and gold. 2010 presented a continuation of such trends.

Making a call for next year implies, in our view, being able to read the political tea leaves more accurately than ever. We feel most political dynamics will not change dramatically in the next twelve months and we will continue to see easy monetary policy from the US and an ECB put strategy in Europe. However, these themes are eventually unsustainable by themselves and asymmetrical risk is building up into the investment framework.

Assuming most political decisions will mimic the past trend, we expect equities to still be an attractive asset class, especially in sectors characterized by high dividends and CPI protection. Lip service to our energy infrastructure MLP strategy is evident here but honestly disclosed. Inflation, in developed economies and especially in Emerging Markets, is a reality in spite of a system in desperate need to de-leverage some parts of its balance sheet.

In this light, commodities and gold specifically will probably experience volatile moves but within upward trends. Beyond gold, which was our successful 2010 call, we think crude oil will be a natural price leader in this asset class.

Bonds look more risky than most other investment options. US Treasuries suffer from undefined fiscal restraints and debt monetization and therefore only inflation protected securities should be included in portfolios where a risk free instrument is still required. Among other sovereign bonds, we continue to favor Emerging Markets bonds but with a lot less enthusiasm than a year ago. Corporate bonds should also provide lackluster performance if the general level of interest rates continues to move higher.

Potential game changers: Forex dislocations, large sovereign default in Europe, social instability in China due to uncontrollable inflationary pressures. It should be interesting…

--Davide Accomazzo, Managing Director
(Written January 7, 2011)

Alpha, Beta and Heisenberg Uncertainty

In physics, complementarity is a basic principle of quantum theory closely identified with the Copenhagen interpretation, and refers to effects such as “wave–particle duality,” in which different measurements made on a system reveal it to have either particle-like or wave-like properties.

Niels Bohr is usually associated with this concept, which he developed at Copenhagen with Heisenberg, as a philosophical adjunct to the recently developed mathematics of quantum mechanics and in particular the Heisenberg uncertainty principle. The Heisenberg uncertainty principle states that certain pairs of physical properties, like position and momentum, cannot both be known with precision. That is, the more precisely one property is known, the less precisely the other property can be known.

In Chinese philosophy, the concept of “yīn yang” is used to describe how polar or seemingly contrary forces are interconnected and interdependent in the natural world, and how they give rise to each other in turn. Yin yang are complementary opposites within a greater whole. Everything has both yin and yang aspects, although yin or yang elements may manifest more strongly in different objects or at different times. Yin yang constantly interacts, never existing in absolute stasis as symbolized by the Taijitu symbol.

A similar paradox exists within the CAPM paradigm involving the relationship between the concept of "beta," as determined by the market portfolio, and "alpha," which loosely represents "a proxy for manager skill". As suggested by our blog, "The CAPM Debate and the Search for 'True Beta'", the yin yang “whole” relates to the “True Beta” concept which Jagannathan and Wang (1996) theorized must encompass “the aggregate wealth portfolio of all agents in the economy”.

Schneeweis (1999) in his article, “Alpha, Alpha, Whose got the Alpha?,” writes about a related problem with respect to measuring “alpha” by raising the question of “how to define the expected risk of the manager’s investment position”. In other words, when marketing “alpha” portfolio managers often assume “the reference benchmark is the appropriate benchmark and that the strategy has the same leverage as the benchmark”. Further, “[w]ith the exception of a strategy that is designed to replicate the returns of the benchmark, the alpha generated by this approach is essentially meaningless”.

Schneeweis (1999) makes the case that investors often make the mistake of relying on a single-index model as a meaningful benchmark from which to gauge the factors “driving the return of the strategy” when often a “multi-factor model should be used to describe the various market factors that drive the return strategy”. The problem is that statistically it is “better to over-specify a model… than to under-specify. If the model is over-specified, many of the betas will simply be zero. However, if under-specified, there is the possibility of significant bias”.

Which brings us back to the Heisenberg uncertainty principle...

Just like the physical properties of position and momentum cannot both be known with precision, the properties of “alpha” and “beta” can also not be measured precisely. This statement has been interpreted in two different ways. According to Heisenberg its meaning is that it is impossible to determine simultaneously both properties with any great degree of accuracy or certainty. According Ballentine this is not a statement about the limitations of a researcher's ability to measure particular quantities of a system, but it is a statement about the nature of the system itself as described by the equations.

- Mack Frankfurter, Managing Director

Alpha Alpha Whose Got the Alpha - Schneeweis

Schneeweis, Thomas. “Alpha, Alpha, Whose got the Alpha?” University of Massachusetts, School of Management (October 5, 1999).

Jagannathan, Ravi; McGrattan, Ellen R. (1995). “The CAPM Debate” Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 19, No. 4, Fall 1995, pp. 2-17.

Bohr, Niels. Atomic Physics andHuman Knowledge, p. 38.

Heisenberg, W. Über den anschaulichen Inhalt der quantentheoretischen Kinematik und Mechanik. In: Zeitschrift für Physik. 43 1927, S. 172–198.

Ballentine, L.E. The statistical interpretation of quantum mechanics, Rev. Mod. Phys. 42, 358–381 (1970).