Saturday, June 23, 2018

Tobin's separation theorem - It can be applied anywhere

One of the greater principles of investment finance is Tobin's separation theorem which is a powerful simple tool that can be used for any investment portfolio, but is especially useful when thinking about managed futures and alternative risk premiums. (Robin Powell reminded me of Tobin’s contribution in his essay, Can you really stomach the risk you’re taking?) There is a tremendous amount of useful investment advise through just applying the simplest of concepts. 

Tobin's Separation Theorem is elegant in its simplicity. Find the risky portfolio that maximizes the return to risk and then form a new portfolio that combines this risky portfolio with cash or leverage to find the level of risk that will make you comfortable. The new portfolio, set to the volatility you want, will be on the tangent line for the max return to risk. The new portfolio will be a combination of the risky portfolio and cash if you want less volatility. Similarly, the risky portfolio can be levered to a higher level of volatility. 

The Tobin Separation theorem is especially useful for thinking about managed futures portfolios or alternative risk premiums using total return swaps. Because both use margin at a low level, the risky portfolio can be set at any level desired by the investors through notional funding. 

For example, in managed futures, if the manager sets his base portfolio at a volatility target of 10%, the investor could fund a separate account for say $10 mm and set the notional exposure at twice the cash level or $20mm of notional exposure for 20% volatility on the $10 mm investment. The investor achieves the higher risk at the same return to risk trade-off. Managed futures managers understand the separation concept very well through their setting of volatility for their funds.

In the case of alternative risk premiums (ARPs), there may be a set of strategies that generate an information ratio of 2 but only has volatility of 2% and a return of 4%; however, a pension fund may have a discount rate of 7%. The ARPs may be a great investment but at a return of 4%, it will be significantly less than the expected return needed for the pension. The ARPs better be good diversifiers or there will be a return shortfall. In this case, the separation theorem tells us that we can view this as the risky portfolio that can be levered to a higher volatility that will be closer to the discount rate. Low volatility combinations of risk premiums can be levered through notional funding to a risk level more consistent with the desire of the investor.

Similarly, if an investor starts with a portfolio that has a beta of one but would like lower market exposure, it is easy to just reduce the beta exposure with an increase in cash to the level desired. It can be done through cash and the risky asset without resorting to greater complexity.

Find the best return to risk portfolio and then adjust to the volatility desired. If this can be done with investments which do not need to borrow such as swaps and futures, all the better. This approach is both elegant and simple. 

Friday, June 22, 2018

Commodity returns over the long-run - A good diversifier, so get back in with an asset allocation

Commodity index investing has not been very successful for investors as measured by leading index total returns since the Great Financial Crisis. The end of the super-cycle has been tough on most investors and only recently has there been a period of extended positive returns based on the rise in oil prices. Is there any relief for investors?

A look at long-term returns for commodity futures suggests that this period is not representative of what may happen in long run; however, long periods of negative performance are not unusual. The recent paper, "Commodities in the Long  Run", published in the Financial Analysts Journal studies commodities since almost the beginning of the Chicago Board of Trade, a period of 140 years. It finds that commodity futures indices have been significantly positive over the large time period, albeit with high volatility.

The work also shows that the key driver of commodity futures returns are the interest rate adjusted carry and not the spot price. Backwadation and contango do matter and this carry effect is different than the movement in short-term interest rates. Backwardation is a strong positive condition for commodity returns. Additionally, performance will differ on the macroeconomic conditions with high inflation and growth being two states that positively impact return performance. Notably, in an inflation up and expansion period commodity returns are positive regardless of the backwardation or contango.

Commodities will add value as a diversifier to a portfolio especially during certain economic states like higher inflation. Given the low correlation to stocks and bonds, volatility will be lowered with even a small allocation to commodities and there will be an increase in Sharpe ratio. The benefits from commodities can be achieved either through a long position or a long-short position through backwardation and contango.

Our view is that commodities should be incorporated as a core allocation for a well-diversified portfolio but this allocation should be dynamic. Periods of sharp economic downturn should call for lower allocations or exposure through long-short carry positions. More importantly, asset allocation decisions should not be skewed by the recent post financial crisis return performance but should be based on a longer-term view consistent with the data.

Thursday, June 21, 2018

Decision noise reduction - This is the one thing investment managers should get right

"There's a lot of noise when making a decision. Not in the decision itself, but in the making of the decision. It is possible that an algorithm, and even an unsophisticated algorithm, will do better because the main characteristic of algorithms is they're noise-free. You give them the same problem twice, you get the same result. People don't." 

- Daniel Kahneman keynote at the Morningstar Investment Conference in Chicago 2018

What is the one thing that investors want from a manager? Consistency in performance. There is value in the "smoothness" of returns. Smoothness is not the same as volatility. A manager can be volatile but still be consistent in that it applies the same reasoning to the same set of facts or market conditions. The smoothness comes from the fact that returns will match a set of factors that can describe the investment decision process.

Decision consistency or decision noise reduction is important across all professions. We want a radiologist to reach the same diagnosis for the same x-ray. We want a judge to rule in the same way for a similar crime. And, we want a money manager to behave the same when faced with the same economic conditions. 

Return consistency is achieved through the same application of decision-making. Having the same process for decisions should reduce performance noise in that the performance pattern will be similar given the same set of price behavior. It will not ensure protection from loses, but consistency may allow for longer-term success. Of course, if the wrong process is applied consistently, there will be a problem.

Of course, some will say all decisions are situational and cannot be placed into a neat framework. No situation is exactly the same, but we believe the odds are more favorable when a disciplined approach is applied. Consistency should be a fundamental issue for discussion during a due diligence.

Wednesday, June 20, 2018

The "Hedgehog and the Fox" revisited - Find managers with big ideas, but diversify

The Greek poet Archilochus wrote, "The fox knows many things, but the hedgehog knows one big thing."

The Oxford philosopher Isaiah Berlin used the fable of the hedgehog and fox as a metaphor for the writing of Leo Tolstoy in War and Peace. In "The Hedgehog and the Fox”. Berlin used the fable as a way to describe thinkers and writers. There are two types, those who define the world through a single idea versus those that have a variety of experiences and cannot be defined by a single idea but by many. Some writers are hedgehogs while others are like foxes. In the case of Tolstoy, he thought like fox and wrote about many ideas but desired to have one big idea. He could not be classified as a hedgehog or fox and this was a source of conflict, a "fox by nature but a hedgehog by conviction".  

Since the writing of Berlin in the 1950’s, the hedgehog and fox analogy has gone from a description of thinking to a more negative view on forecasting. Phil Tetlock used the fable to describe types of forecasters. The fox uses many sources of information and thinking to develop a prediction versus the hedgehog who has only a single idea that is less effective at explaining a dynamic or uncertain future.

We think that the original idea of Berlin coupled with the thinking of Tetlock is a useful for describing the thinking of hedge fund managers. There are those that have a single big idea or philosophy for how the investment world may work. The hedgehog could be the systematic trend-follower, the value manager, or the short specialist. The fox is the manager who is the diversifier. He does not have a guiding or unifying philosophy but rather is willing to combine different ideas to find the best strategy or idea to implement. There is no philosophy other than to use what works.

We respect the hedgehog that has the one big idea or can articulate the well-defined strategy but we also realize that a fox may protect us from the failure of the big idea through its flexibility. A key choice of the investor is to either find the fox manager or diversify across a set of hedgehogs. In either case, the single big idea can be costly, so there is value with running with the foxes of Tetlock or bundle a set of big ideas to stay diversified. Big ideas are critical, but it is important to have more than one of them in an uncertain world.