Active Beta? What’s that? It is our term for a systematic and relatively passive way to enhance returns by capturing risk premia but at the same time manage risk and provide a real long term edge over standard buy and hold.

Having read countless books and papers preaching the long term upward drift in stock and bond prices we realize that risk premia is a good thing. Of course after having come through the 2000-2003 bear market we also know that if risk premia is good then risk management is even better. After reading Jim Leitners’ interview in the book Inside the House of Money we started to look at different ways we could gain more exposure and safely earn risk premia by using systematic strategies that have us involved in different asset classes.

Currently we have models built to capture risk premia in equities and fixed income. We are still working on ways to capture it in currencies and precious metals/commodities. We have built, bought, and researched several timing models over the years that are based off of technicals, valuations, sentiment, monetary inputs, and any mix of the above. Over time several of these timing models have proven to have a substantial edge over buy and hold especially when it comes to risk control. We have experimented with several different ways to use these models but so far have found that simpler is better and for each bullish model we enter X%. Currently for both fixed income and equities we enter 10% of our position for each model that is bullish using up to 50% of the model portfolio.

Right now we are working on a currency model that takes advantage of the carry trade, but with a risk management filter. We had been struggling to do it in a systematic risk controlled manner but thanks to a post by Macro Man we may have found a solution. If the testing works out we will post an update. As for the Precious Metals/Commodities model portfolio we are working on a CTA technical trend following model. We questioned calling this an Active Beta strategy but after re-reading some research by Bridgewater we decided that with the relative ease (No, it’s not actually easy. But once you have it up and running you shouldn’t have to tweak it much to keep it running.) to maintain it we would include it as Active Beta. Expect more posts on these models in the future as we get further in our research.

Happy Trading,

The Macro Trader

P.S. If you liked this post please add us to your RSS reader. if you have any questions, comments, praises, or criticisms feel free to e-mail us at Editor@TheMacroTrader.com

For further reading on Active Beta and systematic capturing of risk premia, here are some links to go to.
Inside the House of Money Excellent book filled with interviews with leading Global Macro Traders.
Pioneering Portfolio Management Must read book by David Swensen, portfolio manager of the Yale Endowment Fund.
Formula Research Nelson Freeburg builds some of the best systems out there.
World Beta blog Mebane Faber has done a lot of work on systematic methods of reducing risk.
Macro Man blog Macro Man has lots of witty takes on the markets and does quite a bit of solid research.

Here at The Macro Trader we run five different model portfolios: US equities, fixed income, precious metals, foreign equities, and currencies. We use ETF’s and the occasional Closed End Fund as our trading vehicles.

The starting value of each portfolio was $100,000.00. We typically risk from .5% to 2% (usually 1%) on each position, with each position taking up no more than 25% of the model portfolio’s equity. So for example, with a $100,000.00 portfolio, we would risk no more than $1000.00 from entry to stop on one position, and that one position initially could not take up more than $25,000.00 in equity.

We track each model portfolio against two different benchmarks: The 0-line and the standard benchmarks in their asset class. We use two benchmarks for two reasons: First we believe in absolute returns. Our newsletter is patterned after a Global Macro Hedge Fund, so we pay strict heed to risk controls and positive returns. Who cares if you beat the SP500 because it lost 25% that year, and you “only” lost 20%? Sure, you may have won in Morningstar’s eyes, but you and your investors lost real money. In addition as long as you have positive returns, you could potentially lever up your portfolio to juice up your returns if your trading is sufficiently risk-adverse.

That said, we also track our relative benchmarks because people are used to them and doing so helps us gauge the effectiveness of some of our risk-taking. For instance, if we are taking on a lot of risk and are lagging our relative benchmark, then we need to scale back. If on the other hand we are beating the benchmark while taking far less risk, it may be appropriate to take on a bit more risk. As we will discuss later in this post, the latter situation has been our problem as of late.

US Equities

When we started the letter we had been bearish on US equities for some time. That said, we remained in cash until our 2/1/08 issue when we went short the XLF-Financials ETF. So far we have had three closed out trades. Of the three trades, two were profitable and one was closed at a loss. Our return has thus far been 1.57%. In the same time the SP500 has returned -3.28%. So on an absolute basis we are positive with a 1.57% return and on a relative basis we are beating the SP500 by 4.85%.

Fixed Income

In fixed income our first trade came in the 12/28/07 issue and was a buy of the TIP-TIP’s ETF. Since then we have had six closed out trades and currently have one open position. Of the seven trades all but one has been profitable. Our total return has been 1.9%. In the same time our primary benchmark the TLT-20 Year Treasuries has returned -4.1%. So on an absolute basis we are positive with a 1.9% return, and we are beating our benchmark by 6%. (By the way, as the universe of fixed income ETF’s expands we may change our benchmark to the Lehman Aggregate Index AGG-ETF)

Precious Metals

The first trade we had in precious metals came in the 12/7/07 issue. We went long GLD-Gold ETF. Since that time we have had three total trades in the metals portfolio and all of them have been profitable. Our performance has been good with a 5.23% return which beats the XAU Philly Gold/Silver index by 5.24% and the price of gold by .89%. We were able to achieve this while never being more than 54% invested.

Global Equities

Our first trade was a short in the EWW-Mexico ETF in the 12/1/07 issue. Since then we have had a total of six positions. Four of them have been closed out, and we currently have two open positions. Of our closed trades, three were losses and one was profitable. Currently our two open positions are profitable. Our P/L for this portfolio is -1.33%. That of course comes out to a -$1,326.48 loss. On an absolute basis we are obviously down. Depending on the benchmark used, we are either a bit ahead of a bit behind. Using the EFA-ETF which returned -6.64% we are ahead by 5.31%. Using the EEM-ETF which returned -.09% we are behind by 1.24%.

Currencies

We didn’t have our first currency trade until the 2/22/08 issue. Since then we have had four trades: Three winners and one loser. We are up 3.12%. As of now we are using the DBV-Currency Harvest ETF as our benchmark. Since there is no real benchmark for currencies, we decided to use the carry trading DBV-ETF as a benchmark. The DBV is down -3.71%, so we have beat our benchmark by 6.83%.

Overall the model portfolios are up 2.1% as of today’s close (5/7/08). Of our 20 closed out trades 14 have been winners and six have been losers. Our winners have made $13,894.01 and our losers have lost $3,675.88 for a total gain of $10,218.13. We currently have three open positions, all three are profitable, adding an additional $278.70.

While evaluating our performance, we have realized that we need to take on more risk. With a 70% accuracy rate and a 3.78 profit factor we should probably either be bigger in our positions, have more open positions, or a combination of both. Going forward this will definitely be an area that we will be working on.

Happy Trading,

The Macro Trader

As mentioned in previous posts we run a variety of automatic as well as discretionary trading systems. Running them alongside each other helps us to spot market trends that we might not otherwise see. Well here are a few macro themes that we have found and currently are tracking for good entry points with relatively low risk.

Energy and Raw Materials-Yes, we know that this isn’t exactly a novel idea. But the fact remains that if the world is to continue expanding we are going to need more energy. If more people in third and second world countries are buying cars guess what they need? Yeah you guessed right. They need gasoline and the car companies need steel. If the BRIC’s and friends are to continue growing at their current pace or even half of the current rate then they need raw materials and energy to build. So we are for the most part energy and hard asset (commodity) bulls. While an index probably isn’t a bad way to go we feel that we can get better risk adjusted returns by looking for our own trades and scaling in and out of different securities. So we track a lot of different individual stocks, ETF’s, and commodities.

Housing-We are housing bears. While we don’t see this trend continuing forever or even for ten years we do see it going for at least another year. Does that mean we are shorting everything in housing? No, in fact we currently only have one short position in housing (HOV). But it is a theme we will continue to monitor.

Healthcare-Ultimately the outcome of the health-care industry is probably going to end up with politicians deciding if it is allowed to win or not. For the next 40 years we see several reasons to be long healthcare. Unfortunately we see a reason to be very hesitant. Because of the aging populations in the western world the bulk of the voting population will probably favor government controls on the health system. That being said we still see many potential opportunities in healthcare and bio-tech.

Global Telecom-This is a theme that has been good to us off and on for some time now. We have found that in a lot areas of the world some of the best stocks have been in the telecom industry. Off and on we have been long VIP, MBT, AMX, CHL, SKM, and TKC. In fact last week we re entered TKC. Basically telecom is one of our favorite emerging market industries and whenever a country meets our other criteria it is usually one of the first areas we look at.

These are some of our major trading themes right now. We have other themes we monitor but these should give you an idea as to where we are looking and what we look for. Basically we look for areas that should have long lasting trends and real fundamentals. We then look for entries that present a good risk to reward scenario. We aren’t in the business of risking a dollar to try and make a dollar. We are looking to risk a dollar to make three or four and sometimes even ten.

If you have any questions feel free to contact us here. And if you like what you have read you will want to add us to your RSS reader and consider subscribing to our newsletter.

Happy Trading,
The Macro Trader

Our last post discussed the advantages to using systematic investing processes along side discretionary trading. Here is a great example of this in practice.

In our Junk Bond Model we track several Junk Bond Funds and indexes. We do this so that we aren’t burdened with mutual fund trading restrictions and so that we have a fuller view of the High Yield Bond market. In this example we are using PRHYX the T Rowe Price High Yield Bond Fund. It is actually one of our favorite Junk Bond Funds because among other reasons it tracks the index very well and has a long history.

Looking at the results of the PRHYX its year to date (YTD) performance has been OK. On a total return basis it is up +3.9% this year with a maximum drawdown of -5.69% and a current drawdown of -1.56%. Looking at the results of our Junk Bond Model we have a YTD return of +5.6% with a max drawdown of -.71% and a current drawdown of -.71%.

If you look at the chart below you can see the results of investing $100 in the Junk Model versus $100 in he PRHYX Bond Fund.

Obviously the Junk Bond Model was able to sidestep the huge drop this summer and has avoided most of the current downturn. If you had invested in the Fund you would have taken on almost six times the risk for less return than trading the Junk Model. By the way the main inputs for this model are price action and interest rates.

This is an example of a model we use in our trading. As stated before we do this so that we can have uncorrelated, consistent, outperforming returns over time. We look at several asset classes, across as many countries as we can, using varied trading strategies. We do this because we are looking for the best risk to reward trades on the planet.

Happy Trading,

The Macro Trader

P.S.-If you liked this you will love TheMacroTrader.com Newsletter and will want to add us to your RSS Reader.

UPDATE-So far for the year 2007 our Junk Bond Model is ahead of the SP500 in both absolute and risk adjusted returns.  The SP500 is up 2.87% and the Junk Bond Model has returned 5.86%.  And what about drawdowns?  Well the SP500 has had two drawdowns slightly larger than -8% and few in the -5% range.  The Junk Bond Model’s worst drawdown is still only -.71%.  So yes, long term (and short term as well) adding different asset classes and trading strategies to your overall portfolio does help returns, diversification, and your risk profile.