Some Benefits Of Trading Across Asset Classes-Or An Advertisement For Global Macro

With only a few weeks left in 2015 it would be a fair statement to say that there has been a lot of troubles in the asset management business. US Stocks are flat, bonds are flat, foreign stocks are down, commodities are down, junk bonds are down, and gold is down.  Here is a year to date performance chart of some of the major asset classes.  As you can see it has been less than ideal for the long only world.

Asset Classes

Some Major Asset Classes YTD

Years like this are why we are such big fans of being able to go long/short across asset classes.  In our model portfolio equities have been a drag in 2015 of a bit over -4.00%. We were short emerging market stocks for part of their fall but aside from that we mainly lost money on our equity trades.  Fixed income added slightly less than +1.00%. Being short commodities off and on, gold and copper, has added around +5%. This year currencies have been our big winner adding over +13.00%. As of last night our model portfolio is up 15.60%. Our worst drawdown on the year was -5.35% and we are currently down -1.83 from our equity highs.

TheMacroTrader.com Model Portfolio Equity Curve 2015

TheMacroTrader.com Model Portfolio Equity Curve 2015

If we had a fixed mandate of being only long equities, long fixed income. or long anything we would have been flat at best and probably negative for the year. Instead we had the flexibility to go where we found the best risk/reward opportunities.

 

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

 

 

 

One Thing All Investors Can Take From CTA’s and Risk Parity Funds

If you follow the alternative investment landscape at all then you have heard of both risk-parity funds as well as CTA’s-Commodity Trading Advisors.  Regardless of what you think of either strategy there is one thing that most investors should look at adapting to their particular style of trading/investing.

What “thing” am I talking about? Well the one component that most of them use in their trading process is to equalize the risk on each of their positions. Most CTA’s use a volatility based position sizing model of sorts while one of the goals of risk-parity is to bring each asset class up to the same risk level hence the parity in risk-parity.

In the case of a CTA they might use the last 20, 60, or 100 days to measure the volatility of the instrument. They might use standard deviation, average true range, or any number of other volatility based measures. Risk-parity funds tend to look at the long run historical volatility of an asset class. The time frame is of course dependent on their average holding period. Most risk-parity funds are relatively slow moving asset allocation shifts as volatility rises and falls while most CTA’s are medium term trend followers. So while a risk-parity fund might only adjust their allocations once a year a CTA could have 300% turnover in a year.

But while their time frames are different the ultimate goal remains the same. In both cases they are trying to normalize risk in an algorithmic fashion. This does two things. One is obviously to normalize risk across assets. The second is to take the human decision out of the equation.  Both reasons have a lot going for them but I suspect that most investors would benefit from the second reason more than anything else.

In general humans tend to be over or under confident. When it comes to investing it is almost always hubris that hurts but in some cases it is still under confidence.  By being as systematic as possible we can eliminate, or at least reduce, our bad tendencies while accentuating our good tendencies.

As an example I have always been far too risk adverse. I started off as a broker catering to very active traders. In this environment I saw a few people make a ton of money and a ton of people trade their accounts into oblivion. This experience made me very risk adverse and consequently my drawdowns have always been very small. The bad part of very small drawdowns is that it makes it that much harder to have very good upside. I always rationalized that “I will add more to the position later” when in practice that rarely happened. Over time I realized that if I doubled my drawdown size I would be fine and yet my upside would also double. To put this in perspective I have never had a -10% drawdown.

I always paid lip service to position sizing models but usually ended up taking 1/2 and sometimes even 1/3 of the suggested position.  I have a solid risk management process but I was never maximizing my risk taking. Overly cutting off your upside is almost as bad as NOT cutting off your downside as they both lead to far less than optimal outcomes.

I finally decided I was done with that and worked out a position sizing algorithm that in theory I was happy with. I then committed myself to following it….no matter what. I now type in my volatility measurement, buy/short price, stop price, volatility measure and it spits out how big a position to take. My results have not only been far better but also more consistent and all this with drawdowns that are still tolerable. With my revised sizing regime I will eventually have a drawdown larger than -10% but barring some huge gap risk it should never be larger than -20%.

What I have seen across many investors accounts is that equalizing their risk, or at least really understanding how unequal risk is across positions, is a huge benefit to them. Take the traditional 60/40 stock bond portfolio. If you measure your risk you will see that you have far more risk in equities than the 60% would indicate.  If you are really OK with this than fine but most investors….and even most of their advisors don’t even know this.

I could obviously go on and on about this topic and maybe will in a future post. In the meantime I would recommend that you go read up on risk-parity as well as CTA strategies. Whether you like their overall strategy or not is up to you-some people don’t want to lever up bonds to match their equity risk or go long/short soybeans-but they both have some systematic and very useful risk management concepts.

Finally I would say, just like half the industry would say, that the number one thing between many losing or at least under-performing investors/traders is a poor risk management and portfolio construction process. The word “process” sounds so cliche anymore and yet it is a real thing. If you don’t focus on process over outcomes then you will under-perform and likely lose money over time.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

Global Macro-Generate Superior Returns With Less Risk

We at The Macro Trader are obviously fans of Global Macro as an investment strategy and even philosophy. Fortunately the data backs us up showing that global macro not only generates higher returns but does it with far lower risk than equities.

The chart below shows how you would have done if you had invested $1,000 into the Credit Suisse Macro Hedge Fund Index, SP500, and Barclays Aggregate Bond Index since 1994. As you can see the CS Macro Hedge Fund Index did drastically better than either stocks or bonds. To be more specific the CS Macro Index beat the SP500 by 2.11 times and the AGG Index by 2.75 times.  So that shows the returns but what about the risk taken to achieve these returns?

Global Macro vs SP500 vs Lehman AGG Bond Index

Global Macro vs SP500 vs Lehman AGG Bond Index

We have a few different charts to display the risks taken to generate the returns in each index. First we will show the historical drawdown charts. A drawdown is simply anytime you are not at new highs in your account. If you have $100 and lose $5 you are in a -5% drawdown. The deeper the drawdown the higher the return needed to get back to breakeven and the math, while simple, can be tricky. For instance if you lose -50% many think you need to make 50% to get to breakeven. The reality is that you need 100% to get to breakeven. In our case of being down -5% you only need a 5.26% return to get to breakeven but it gets harder the deeper you get.

Looking at a drawdown chart of the SP500 you can see that not only are stocks usually in a drawdown but over the past 20+ years we have had two massive drawdowns that took years to make up. We know them as the DotCom crash and the GFC-Global Financial Crisis. It took the SP500 57 months to recover from the DotCom crash and 50 months to recover from the GFC.

SP500-Drawdowns

SP500-Drawdowns

At the opposite end of the spectrum we have the drawdowns of the Barclays AGG Fixed Income Index. As you can see the AGG Index has frequent but small drawdowns with the worst one barely dropping below -5%. It only took nine months for the AGG index to fully recover from the worst drawdown and three months to recover from the second deepest drawdown.

Lehman/Barclays AGG Fixed Income Index Drawdowns

Lehman/Barclays AGG Fixed Income Index Drawdowns

Finally we have the CS Global Macro Index drawdowns. As you can see its worst drawdown was a -26.79% and its second worst was -14.94%. It took 19 months to recover from the -26% drawdown and 19 months to recover from the -14.94% drawdown.

Credit Suisse Global Macro Index Drawdowns

Credit Suisse Global Macro Index Drawdowns

Another way to show the depth and length of the drawdowns is to plot both the equity line as well as the new highs line. In each of the next three charts the green line equals the highest the equity line got, notice it never dips down, and the red line is the equity curve which goes both up and down.

Here is the SP500. As you can see while it hit a new high in 2007 it then went back down. In essence it took about 12 years before investors were really making new money. While this is a worse than “normal” period it is also not the first or the second time that the stock market has had a rough decade.

SP500 DD and NH

SP500 DD and NH

Looking at the AGG Fixed Income Index we see that the drawdowns are both shallow and short. If you were in the AGG Index you would not make the most money but you also took very little risk.

Lehman-Barclays AGG Fixed Income Index DD and NH

Lehman-Barclays AGG Fixed Income Index DD and NH

Finally we have the CS Global Macro Index. As you can see the drawdowns while larger than that of the AGG index are far smaller than the SP500 index. It kind of takes the middle route in regards to risk but it drastically outperforms both in regards to return.

Credit Suisse Global Macro Index DD and NH

Credit Suisse Global Macro Index DD and NH

Another way to look at the risk and return is to look at the 12-Month Rolling Returns. At any point in the chart you are looking at the returns you would have gotten if you had invested 12-Months ago.  As you can see the SP500-red line has the highest 12-Month returns but also the lowest 12-Month returns. The AGG Index-green line almost always shows positive returns but it never has a really big year. Finally the CS Macro Index-blue line again comes somewhere in the middle. It is positive almost as often as the bond index but the 12-Month period to 12-Month period returns are less than stocks.

Global Macro-SP500-AGG 12-Month Rolling Returns

Global Macro-SP500-AGG 12-Month Rolling Returns

Basically global macro has lower volatility and more consistent returns than the stock market and almost as consistent returns and far more gains than the bond market.  The main reason that this is possible is that as opposed to either the stock or bond index a global macro fund can go long and short anything and trade derivatives on anything. Most macro managers stick to liquid instruments but that still means you have hundreds if not thousands of tradeable instruments. The flexibility inherent in global macro allows you to always find a bull market somewhere whether that is being long stocks, short stocks, long the Australian Dollar, or short the Australian Dollar. You can bet on US Treasuries against German Bunds or across almost any other market relationship you can think of. Not only is global macro flexible but macro managers are famous for stringent risk management practices. It is almost cliche but in the end risk management is one of the keys to success in any trading approach and one of the most important things that separate macro from long only buy and hold.

What about claims in the press that “hedge funds have under-performed the SP500 since the GFC?” Well that is true but if you are picking only half a cycle than it is probably not a fair comparison. In the chart below you can see what happened to the CS Macro Index and the SP500 from the end of 2008 until the end of August 2015. As you can see the stock market is ahead.

2009-Now

2009-Now

Of course that was just in a bull move when everything was headed up. If instead of the end of 2008 or the end of February 2009 we use 2007 as our starting point we get a drastically different result. In this case the flexibility and risk reduction inherent in the global macro approach shines as the CS Macro Index outperforms the SP500 with both higher returns and far lower risk.

2007-Now

2007-Now

As far back as we have data global macro has outperformed both stocks and bonds across full market cycle. On the other hand long only equities has been profitable but has had some very long and deep periods of negative returns.  We are obviously biased towards global macro. We have a site and run a research service dedicated to it. You could say we drank the kool-aid and live and breathe this stuff. At the same time however many of the most successful money managers in history have been macro managers and the data shows that when done right it can lead to both higher absolute and risk adjusted returns.  So while we are indeed biased we think that the case is fairly strong in our favor.

 

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

How To Lose All Your Money….Or At Least More Than You Should

Today was the most watched Fed Day in years…and that’s saying a lot since every Fed Day seems to be the most important ever. US rates tanked across the board while other markets mostly flew higher only to close lower.

In our model portfolio we gained a whopping 8 basis points. That is 0.08% for the day. It obviously would have been nice to have gotten everything right and make more but the flip side is that we REALLY don’t want to get everything wrong and lose a lot.

One of our goals over the years has been to get the portfolio to where no one event, at least not a normally scheduled event, poses much risk to us. If a nuke lands in a major city we could take a big hit. If an alien lands in DC who knows what would happen. But if the Fed has a scheduled meeting we should not be overly exposed to anything that has much of a chance of happening.

One way we are able to do this is by diversifying across asset classes. In fact one of the best things about macro trading is that you are kind of supposed to go across asset classed looking for great risk/reward situations. Being long and short across assets is one way to minimize event risk. Another way is to have trades on with different primary drivers such as growth, inflation, relative value, events, etc. Basically bet on a diverse set of risks across a diverse set of assets.

Why stop there however when you can then focus on price correlations, structuring your trades, sizing your trades, and the placing of stops?

All of this to say that if you want to eventually lose all of your money then make sure that you don’t do any of the above. Make sure that your entire portfolio is based on being completely right on one thing. To make it even more fun ensure that the one thing has a small chance of happening. Why bet it all on a Fed outcome when you can go all in, even levered, on a bet that the USD will collapse and our entire system will go back to the stone ages.

While some of that was said in jest….at least kind of, the reality is that many long term portfolios are setup to only do well in one economic condition and even more “trader” portfolios are betting on one or two outcomes on different events.  If you want to improve your risk adjusted, as well as your absolute, returns then pay attention to this stuff, think about it, study it, etc. and see what you can do to improve your risk and diversification processes.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research

 

 

Optimists Survive By Eating Bears

Today (9/10/15) David Tepper came on CNBC for an hour. The whole discussion is worth watching but one thing he said is missed time and time again by many investors.

“I’m not real comfortable being short stocks because there’s a bias for stocks to go up over time”-Tepper

Tepper has been putting up 25-30% returns for over 20-Years with billions under management. He is one of the best traders in history, great at sizing up risk reward, security selection, and timing….and yet he says “I’m not real comfortable being short stocks because there’s a bias for stocks to go up over time.”

One of the sub-segments of the investment/econ space that I enjoy are the “end of the world as we know it” genre. They are mainly published at market bottoms while the super bullish books are published at market tops (remember Dow 40,000?) but we also see a lot of them mid cycle as well. For whatever reason doom and gloom sells very well. The short argument always sounds like the intelligent argument. To make it worse there is always a lot of data that shows real reasons to be worried. Look at any of the books in the picture below and they are filled with data and charts showing impending doom. If you look at the publishing dates however they either missed the crash or just got the entire thesis wrong. (BTW I recently moved and have not unfinished packing or I could have shown a stack four feet high of end of the world books. For whatever reason I cannot resist the urge when I am in a used bookstore).

The end of the world

The end of the world

What the perma-bears get wrong is that over time civilization has indeed improved its lot in life. Yes, there are downturns but more often than not stocks go UP and not down. If someone as smart as Tepper is wary of shorting then what does that say about what you should be doing?

Looking at US assets over time using data from the Credit Suisse Global Investment Returns Yearbook we can see that stocks go up….a lot….over time. Even after taking into account inflation you would have 1,396 times your money from 1900-2014. Bonds and bills are less explosive but even there they go up over time.

Cumulative Real Returns USA

Cumulative Real Returns USA

Over the past 115 years you would have been fighting a 6.5% annual upwards drift by shorting stocks. That means that you are fighting a 0.54% hurdle each month. And of course that doesn’t even include any borrowing costs, commissions, or taxes.

Annualized Real Returns USA

Annualized Real Returns USA

Now all of this is not to say that we don’t short because we do. We have had success going long and short across asset classes to include stocks. What I am saying is that you need to have a really good reason to fight long term trends in markets. If you can’t figure out why you have an edge on any given trade then you are probably better off not doing it. Oh and in case you are wondering “stocks are overvalued” or “Because the Fed” are not sufficient answers.

If you want more info on the long term bias of stocks to go higher, or just want to get a lot smarter, pick up a copy of the book “Triumph of the Optimists” by Dimson, Marsh, and Staunton.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Take a $1 trial of The Macro Trader to receive unbiased actionable research