More importantly, professional traders see the value in diversification, but not just in a superficial sense. We like to call it multi-faceted diversity. In layman's parlance, it is diversity across a trading or investing portfolio that is accomplished through a series of different strategies. This is a crucial aspect which a lot of retail traders and investors miss out on because they were never taught to think in such a direction.
From the get go, professionals are intently keen on only one performance metric: Risk-adjusted returns. As we stated in our previous edition, it does not matter how high gross returns are if risk is not measured and accounted for. Risk, or variance in a portfolio's returns is equally important as the headline performance metric because it takes into account the amount of quantifiable risk that a trader or investor was exposed to in order to generate the corresponding returns.
There is a term for this risk-adjusted return metric we are talking about. It is called the Sharpe Ratio. Without going into the technicalities of its derivation, the Sharpe Ratio measures the excess return of an investment or portfolio against the variance of said return and expresses this product as a ratio. The higher the Sharpe ratio, the more favorable the investment or portfolio is. A low sharpe ratio means the portfolio is exposed to a high level of volatility even after factoring in all marginal returns above a risk free money market instrument.
A good example that does a good job in cementing the concept of risk-adjusted returns is that of the Hedge Fund industry. There has been a good deal of talk about how the Hedge Fund industry as a whole underperforming the broad market (S&P 500 as a benchmark). Such talk is entirely misguided. As explained previously, the variance of Hedge Fund returns is generally much lower than that of equity returns (or whatever appropriate benchmark used for comparison). The risk-adjusted returns of Hedge Funds are therefore significantly superior to their benchmark indices, if we view the industry as a whole.
There is ample reason why the old caricature of an ailing Hedge Fund industry hasn't been slayed despite year after year of banter by punters who have little idea about their orations. While growth in the industry has long seen its heyday, Hedge Funds are certainly not a dying breed. In fact, there has never been more money sloshing around in the balance sheets of these funds since the 1980s; a quid pro quo in volatility times like we are now wadding in.
Revisting the subject in the degree of diversification we talked about in Part 1, professionals understand that there is more than meets the superficial eye when mitigating and hedging risks in a trading and investing portfolio.
Talk to any successful trader or portfolio manager and you will discover that they do not rely on a single strategy to generate consistent returns. Diversification to them also means spreading capital across various strategies that fall within their slated approach to the markets. This is extremely valuable, and is also one that most retail traders and investors tragically miss out.
This concept skips the part about diversifying across financial instruments and jumps straight to the point on qualifying a trade or position. We will give readers a couple of analogies to make understanding this crucial aspect a little lighter.
Analog 1: Forex Trading
Take Forex trading as an example. There are a myriad of approaches retail traders use to trade the world's largest market. There are technical approaches (chart reading), and there fundamental approaches (macro trading). In each of these subsets lies an almost infinite number of strategies.
For instance, a technical approach may consist of identifying momentum and trend trading, support and resistance trading, Fibonacci trading, Elliot Wave trading, pattern trading... The list extends perpetually.
Fundamental approaches may consist of global macro arbitraging, economic-linked trading, inter-market and correlation trading, value-price differentials, capital and current account , flow trading, monetary and financial balances...
Safe to say most retail traders involved in the Forex market embrace the technical approach much more than anything else. No surprise here. However, therein lies the rub; technical analysis is inherently retrospective. Charts are basically nothing more than past price action plotted under a set of parameters. Readers should not misinterpret this as "technical trading does not work", but rather "technical trading has its limits". We have spoken to many traders who fall within this category and they have proven that they can be profitable.
We are however looking through the lens of professional traders. The fact is that industry professionals almost never rely fully on the charts to generate consistent results. Their approach may be accurately called a hybrid of the known strategies in the trading and portfolio management universe.
Even when we limit our scope to the technical approach, the importance of diversity can easily been seen as a canary in a coal mine. Trending strategies simply do not perform positively in choppy market conditions. Momentum strategies are a liabilities in slow moving markets. Support and resistance strategies will not be optimal in strongly trending markets, just to name but a few.
Not all strategies under the fundamental approach will work all the time. Much the contrary. In actuality, only a few select strategies will actually work the way they were planned to, depending on the market environment.
A trader that has his bearing fully set on a fundamental approach will need to regularity sustain relatively huge drawdowns on his equity because of the absence of precision in his entires. This will also be a detriment to the amount of leverage he can exercise on each position because of the potentially large drawdowns.
Analog 2: Stock Investing
Portfolio management can take on many shapes and forms, investing being one of them. The nebulous universe of investing is not much different from trading is with regards to diversification in this aspect. Through the traditional lens, portfolio diversification means holding a basket of stocks spread across different industries to smooth out returns.
We take this one step further. There are many approaches to investing in publicly traded companies. Common approaches include the DCF approach is valuations (discounted cash flow), intrinsic value approach (traditional value investing), multiple expansion (growth), relative strength approach (within and across sectors), just to name a few.
An intelligent investor will follow the footsteps of the trained professional in his approach to diversification. Even before individual equity names are selected to be part of an investment portfolio, the approach towards qualifying these holdings should itself be diversified across different strategies.
As is with trading, no single strategy in the investment universe is evergreen. Believing that we foretell with consistent accuracy which strategies will fare optimally during each passing market cycle is a fools game that usually ends in tears. The path towards long term sustainability in the art and craft of investing lies in one's diversification across strategies that form a collective approach towards the markets.
No Single Strategy Works Everytime
This is the gist of today's note. Diversification from the roots. If it is the strategies that define the trades and positions we have on our portfolios, then diversification should be applied to those strategies that we have in our approach.
Professional traders and portfolio managers understand and appreciate this principal. This is why a proprietary trading house has multiple trading desks, each of which are hosts to tens of individual traders whom themselves bear different approaches and strategies to trading the financial markets. An exemplary case of the multi-facetted diversification we talked about in the onset.
One of the keys to long term sustainability in the trading and portfolio management business is an adept grasp and confident mastery of different approaches to leapfrogging a common hurdle of generating superior risk-adjusted returns. The sooner the retail community understands and adopts this, the gentler their learning curve.
- Diversity is all around us, and is in our blood. Learn to love it!
- A proper mindset anchored on consistency rather than reckless risk taking will catapult you to long term success in this business.
- Observe and learn how professional traders and portfolio managers think and act. There is a reason why most retail traders are unprofitable while most professional traders are.
- Diversify from the roots by developing your personalized set of approaches and strategies.
- Always keep tabs on the variance of your returns. Returns should always be placed in proper context to risk.
This coming Thursday, 23 June 2016, the United Kingdom will vote on a historical referendum deciding on the status of its European Union (EU) membership. For the last 2 years since 2014, the UK parliament, led by acting Prime Minister David Cameron have promised a public referendum on Britian's EU membership. Britain's relationship with Europe has always been one of contention, and many have long been awaiting this once in a generational lifetime opportunity to voice their opinions through the democracy of a vote.
The global financial markets have also been eying this key event risk for some time, and since events have heated up recently as we enter the final week before the ballots are cast, there has never been a more important 4 days for English markets (that's including the pound sterling, GBP) since the "Black Wednesday" of 1992 , the day the Bank of England was broken by the markets.
We are not usually pessimists but when we see the writing on the wall getting bold redder each week that passes, we can't help but to take serious note. Just last week, we warned readers that markets might be about to get nastily volatile during the summer. So far so bad. May hasn't started well at all. The S&P 500, as of the week ending this past Friday, posted its first 3-week losing streak since January.
Recent macro developments both in the U.S. and elsewhere have however strengthened the bearish case for risk, in our opinion. It might have reached a point where downside skews in risks make a derisking maneuver potentially more rewarding than chasing beta.
As such, we have shifted our bias to the short side of risk. The positions in our portfolio (which we keep private) have partially reflected this change in view and will continue to do so as the situation evolves.
It is a known fact that credit cycles often lead business and economic cycles. It makes sense on paper and even more sense in practice. This is a subject that we havehardly yet touched on, but will be doing so in this piece. For a majority of the investing community, the topic on credit cycles remain much of a novelty.
As of March 2016, total default volumes on HY bonds (high yield) and institutional loans in the U.S. hit a 6-year peak of approximately $16.2bn, almost half that seen in the entire of 2015. Just this past week alone, we saw at least 4 corporate defaults with 3 in the energy sector.
So far in 2016 (Jan-Mar) default volumes have reached a jaw dropping $32.4bn. To put this in context, 2015's default volume (which was already abnormally high) stood at $37.7bn. If this trend were to continue through 2Q and beyond, we are talking about a full-fledged wave of defaults.
For the first 3 and a half months that have already elapsed in 2016, no asset class has seen the consistent volatility that currencies have. Central banking has been busy, almost too busy, all while the macro fundamental landscape has hardly moved an inch. With all that drama, noise, and play in monetary policies throughout the global economy, one would expect sizable trends in FX. But that hasn't been the case.
For instance, when the ECB first lowered its deposit rate to zero back in the first half of 2015, that sparked a major bear market in the euro, and a bull market in risk assets including euro bonds. When the Fed announced it planned to gradually taper QE3 and eventually end it late in 2014, the U.S. dollar began building up into what we now recognize as one of the most fervent dollar bull markets ever.
Monetary policy divergences used to herald the alpha and omega of huge trends. But not today.
Now, thanks to a comprehensive piece by Bank of America Merrill Lynch, we can provide readers with a glimps of what might be the next big trend in FX.
Last week, Bloomberg broke a story which greatly fascinated us. It involves a mysterious "specter", one which we have no clue about, flooding the Turkish stock exchanges with massive buy orders, massive to the tune of some $450mn in a single day.
Turkish locals refer to this entity (whoever or whatever it is) as "the dude", crowning the figure with an amphibious demeanor worth of a chapter in Slenderman. We have no idea, absolutely no idea who or what "the dude" is, how it specifically operates, and what its motives are for slamming a relatively illiquid market with order sizes so large, they scare the living daylights out of even the staunchest of permabears.
All we know is that local authorities have been rattled, investors shaken off to the sidelines, and a stock market that is now a stellar outperformer in the emerging market (EM) space. Even with the gruesome terror attacks in Istanbul over the weekends, an attack which has killed at least 37 people the last we checked, the Borsa Istanbul Index has now rallied for the 9th straight day.
That's right, we need the U.S. dollar to be BOTH strong AND weak at the same time for continued upside in equities. Much has been said about the greenback ever since the end of the Fed's QE3 program in late 2014. It was then all about king dollar leading up to the Fed's first (in a decade) rate hike in December 2015. Speculators kept piling in on the the freight express train that was the long dollar trade du jour, creating what has become one of the most crowded trades in modern history.
It's likely going to be a tug of war between these forces we've highlighted in this piece. Again, we make no predictions as to direction. We do however expect this conundrum to continue until a novel catalyst emerges that alters the way market participants trade and position. What this novel catalyst is, we don't know.
This conundrum is big, as we shall explain below.
The top 0.01% of the erudite elites control more than 60% of the world's wealth, while the 80% of us have a collective net worth less than the top 1% of society. In a world decorated with such gaping inequalities, risk and opportunities present themselves. While problems may be plentiful, there are also long term opportunities to capitalize on the mother of all trends: A globally aging demographic.
Which is what Janus Capital's Bill Gross, well revered as being called the "Bond King", is driving at in his latest investment outlook. In the race between the tortoise and the hare, the former analogous to a gradually aging population, the latter to technological advancements, the tortoise eventually catches up. Time isn't on our side, and we're sitting in a ticking time bomb.
It's a known fact that a large majority of the world's baby boomers are not adequately primed for retirement, lack the financial resources to meet mounting healthcare and insurance obligations as they further age, and are more dependent on the state's hospitality than ever before. But who pays the ultimate price?
The prospect of $20 oil prices has been raised thanks to this one Black Swan. A Black Swan is also known to statisticians as tail risk, or events that are highly improbable but are of great significance. One can liken such an even to a large meteoroid making its way through the Earth's protective atmosphere and impacting land or sea; an extremely unlikely event but if actually true, mankind's existence would be threatened.
Low oil prices have been the bane of many oil producing and export nations, whose currencies and economies have taken incessant hits every cent crude continues to plunge. The ruthless combination of a huge supply overhang and waning global demand has led to a deadly concoction oil producers and exporters have no choice but to drink. What other choices would they have anyways?
Whatever we said on 5 November came true. For the first time in 9 years, the Fed hiked the Fed Funds target interest rate by 25bp to 0.25-0.5%, ending an eon of zero lower ground rates and marking the start of a new paradigm. A paradigm that is, much as most would hate to admit, unprecedented in terms of scale and bredth.
As we approached 16 December, markets had increasingly discounted a Fed liftoff, but there was still some element of uncertainty. That uncertainty now shifts to what the Fed will do in 2016. Will it continue to gradually hike rates? Will it reverse on its path of monetary tightening and start to ease? These are but a multitude of questions that everyone is asking, but no one can really answer.
Does dovish rhetoric from Europe's ECB, continued stimulus from China's PBoC, the reluctance of Japan's BoJ to step up QQE despite headwinds, New Zealand's RBNZ policy being put on hold signal a soon imminent Fed rate hike?
While correlation might not necessarily be causation, especially in the ubiquitously tangled web of central banking, we believe this development is too significant to turn a blind eye on. Ironically, market-based odds for a December Fed rate hike have never been higher.
Do central bankers know something about the Fed's near term actions which the general market doesn't? If anyone knows what the other will do, it's probably them.
We'll leave this up to you to decide. The proof is in the pudding, and this one's pretty dense. So take it for what it is, we're playing it cautious but not holding our breaths.