Risk: Thinking creatively

Manage
27

Quad - we need to think about how to eliminate systemic risk at the book level. There is nothing more disconcerting than seeing all of one’s ports sinking at the same time. The diversification indicator that I propose will give a good deal of insight and may work in conjunction with market sensitivities such as interest rates, oil, USD, etc. And, if nothing else, the diversification indicator may provide early warning i.e. when one’s holdings start to become very correlated then it is time to think about protecting against a market bear.

At the port level the diversification indicator enlightens subscribers to the ease with which a port could be data mined. Human nature suggests that a model will be optimized as far as possible, despite claims to the otherwise. It should not be considered as a red flag at the port level, but an insight. At the book level it should be a red flag.

Steve

28

Everyone has failed to mention the most important risk factor–especially over the long term:

Performance

First, if you have doubled or tripled (maybe more) your money over the period of several good years you can tolerate a significant loss and still be ahead. Over a long period of compounded returns you are almost guaranteed to be ahead no matter what the draw down looks like.

Second, if you don’t get washed out you can recover quickly.

Third, there is a limit to how much you can control the draw downs on your long positions no matter how diversified you are.

Okay, it is debatable whether this is the most importance factor–but maybe.

29

Jim - the nemesis of performance is overconfidence/greed. As an example, there were many gold traders back in the early 80’s that made a fortune, then lost it all because they kept trading when they shouldn’t have. Great performance leads to overconfidence and greed. After a good run, one needs to be extra cautious and keep emotions in check. Don’t quit your day job, etc. So I would argue the exact opposite of your position.

“Third, there is a limit to how much you can control the draw downs on your long positions no matter how diversified you are.”

In this age of newfangled ETFs that offer short/inverse positions and exposure to various asset classes, hedge funds, etc. I believe that it is possible to control drawdowns. In any case, I don’t believe in blanket statements without any kind of evidence.

Steve

30

Steve,

You are probably right. I was trying not to take a position on hedging.

Still, to be safe with hedging you better do it all the time. And if you are sacrificing a lot of performance, I really am not sure about the reduction in risk over the long run.

BTW, did the gold traders you mentioned use any leverage: I would never recommend that. Also, I’m assuming almost none of us are in just one asset whether it be gold or oil or even airline stocks. Also, I’m not talking about options or futures. It goes without saying that one should stay about an order of magnitude away from gamblers ruin: even in theory. That would be the most important risk consideration.

31

If one wants to address systematic risk, I suspect hedging may be the only way, and as a practical matter, that probably means market timing because, as you said, the long-term reduction in return may prove to be too much.

32

I couldn’t agree more.

While it may be disconcerting to see all ports declining at the same time, equities have a risk premium for a reason. That being said, I agree that it would be great to have better insight into systematic risk, and I was reminded of the concept of market “turbulence” (see link below).

However, it would be difficult (if not impossible) to construct a more resilient portfolio without including other asset classes (e.g., credit, fixed income, currencies, commodities, international equities). Utilizing the current capabilities of P123, the only tool available to use this information is market timing, by selling equities and going to cash when systematic risk is elevated. So I would classify your proposed approach as market timing, not diversification of P123 equity strategies.

33

Quad - that is a very interesting paper.

"Utilizing the current capabilities of P123, the only tool available to use this information is market timing, by selling equities and going to cash when systematic risk is elevated. "

I believe that a book can be constructed that maximizes diversification without the use of market timing. This can be done by an appropriate mix of ETFs and stocks. However, market timing could in theory provide higher levels of return, albeit with higher risk. It really comes down to investor expectations. Some are quite happy to make 8% return per year provided it is reasonably low risk. Others aren’t happy with 50% return per year. If you are in the second camp then of course market timing is the only option as diversification won’t get you there.

Steve

34

I would agree that utilizing ETFs to diversify into other asset classes can help, but P123 is not necessarily the best tool (currently) to arrive at the strategic asset allocation. There are better (though not perfect) tools, such as mean-variance optimization models or Monte Carlo simulation, based on forward-looking capital market assumptions. That being said, I believe that allocation models are best used as directional indications only, since they are flawed (e.g., assuming normal distribution of returns, rebalancing every period), and often very sensitive to even slight changes in assumptions. I would never suggest “goal seeking” (i.e., optimizing) your way to an allocation.

How would you propose implementing an ETF portfolio? The ETF strategies that I have viewed on P123 seem to rotate into the “best” handful of ETFs (e.g., 1-2 ETFs at a time) based on historical performance (e.g., returns, volatility). How is this not market timing?

35

I’ve wasted way too much time on P123 threads in the past… so not wading in much, but the ‘diversification’ problem is fairly ‘simple’ at the book level. Invest in very conceptually different things/return drivers that have logical reasons for maintaining inverse/zero correlations in peak stress market environments. So, managed commodity futures and long-short trend following systems and short only stocks or short-term hi-quality gov’t bonds tend to exhibit this with long-only equity.

Can also hold ‘cash’ and, if you are willing to invest A LOT of time in learning, some dedicated ‘short only’ portions of the portfolio.

So, a simple port ‘book’ of a) personal income (from a job), b) cash, c) short-term, hi quality government bonds from the strongest economy nations, d) long only equity systems (can vary market cap, style, country, etc), e) managed futures or trend following long-short systems (long vol profile for the best managers in historical peak stress times), f) short term real estate or asset backed loans with margin of safety (short term senior credit investments, with collateral and say 60% LTV ratio), g) small’ish (or tactically varied) allocation to short only equity systems, and h) if you want, some market timing stuff… or (optional) i) selling vol through options selling after big vol spikes, with 2-3 year periods (or exit based on VIX levels) of investment followed by cash. There are some good market neutral traders out there as well, they can be added. Or rent generating real estate investments. It’s fairly good in many markets and offers inflation hedge as well. For pure returns, ‘angel investing’ is very good - if you begin at the bottom of an up cycle (we are now likely at the top).

The combination will give you a balanced overall portfolio that is very unlikely to all go down at once.

You can also build ‘simple’ binary systems - Bonds/cash, long-equity/cash, real-estate/cash, gold/cash etc. and allocate to some of these.

Many of these can be done in P123 with ETF’s and stocks if you invest the time, or can hire pro managers. Some can’t be done here no matter what.

A full discussion of ‘risk’ of any one system is something I’ve tackled in many threads in the past, so not gonna dive back in. But good luck.

As far as what is and isn’t ‘market timing’, it’s a giant ‘boogey man’ on this site. Any portfolio that differs from the market portfolio is ‘market timing’ in some way. Everyone market times. They just either do it intentionally or unconsiously.

36

Quad - would you agree that the traditional risk-based strategy of stocks/bonds/cash allocation based on age is a form of risk control? If so, then that is my answer. Yes it can be done. It can be done with stocks, bonds and cash, as a minimum. These can be put into ports without market timing and the book can do the % allocation. With the variety of options we have today I suggest it is possible to improve on that.

And if superior results depend on market timing, then so what? If the market timing can be done in a rational way (such as minimal correlation across securities) while adding more performance than risk, then isn’t that something that should be pursued? I think Marc’s mandate is to improve on what we have, not give up because we don’t already have it.

Steve

37

Tom - I agree with what you say but my position is that if there are tools that will help with the book-level diversification effort then why not have those tools available? I think you can make an educated guess about what to put into a book for minimum risk but you should be able to reduce the guess-work with good diversification tools. It is like driving a car. It may appear to be running well but you don’t know for sure without plugging in a diagnostics computer to tell you what is going on under the hood.

Steve

38

Changing the topic and thinking out loud a bit. We should have an “acid test” for company-level risk. Whatever Marc decides upon should be able to identify risk in various companies that have collapsed. A good example is FXCM , instantly put on life-support by government policy reversal. FXCM deals in FOREX which is high leverage, but is there anything on the books that would indicate such risk?

FXCM is also a good response for anyone that believes Black Swans are rare events.

Steve

39

Steve,

There are many things that can be done at the book level and I’ve posted on many of them in the past… there doesn’t seem to be any want or desire for them.

For example:
a) Allow people to create ‘rules driven’ books to auto adjust the total amount of cash invested in a book with mechanical rules - for example, this will allow risk targeting or beta targeting.
b) Allow developers to adjust the amount of hedging on a book based on rules - so, if there is a DD of 10-20%, can add X% hedge at the book level, if DD of 20% to 40% can adjust hedge amount, etc.
c) Allow developers to use buy and sell rules in a book with constraints, so we can set maximum position sector or asset class weights, or trailing period max correlation constraints, etc.
d) Allow for creation of long-short books, with ‘beta matching’ and total sector controls. This would allow professional-light type long-short systems.
e) Allow for user inputs on ‘total book level’ constraints - for example, cap size, long, short, position level, industry, etc.

I doubt many users would use these, but this is how professionals begin to use rules to drive books. As it is, if you don’t build the systems and someone else does, and subsystems are optimized, then combining them in books just makes it worse.

Best,
Tom

40

I also suggested year(s) ago that P123 save all launched R2G’s. Over time, can build real data driven models of what drives consistency over time in out of sample vs. in sample. Can look at things like total factors in ranking, number of hedges, total gross exposure, sector concentration, number of positions, etc. over several hundred systems from many designers. If no R2G’s are deleted, it’s valuable and can begin to extract ‘probabilities’ of certain factors driving consistency out of sample. However, this wasn’t followed, I think. And no need it should be, it’s not my company.

Something like Omega Ratio can be added (although it won’t detect overfit systems, it’s another useful - or Marc would say, useless ratio). I have seen studies of ‘ranking traders’ for 3,6 and 12 months go forward performance based on trailing period returns. Sharpe, Sortino and Omega all have some statistically significant positive results - although many multi-manager allocators claim to have much better proprietary models.

As far as ‘company level risks’… can identify the largest down day in a company’s history, as well as the largest down day (or 5 down days) in the past 20 years in the most closely correlated companies (on major factors such as size, financial quality, industry and ‘earnings misses / beats’ to this one). Can also look at ‘factor extraction’ to try to figure out which industry or company this company is most like on those factors and then look at the largest historical DD’s of the those most closely matched companies. Looking to create a multi-factor model that ‘predicts’ extreme events and ‘risk of ruin’ for this ‘type of company’ based on the companies ‘grouping’, not just the company’s history. Sorry, I don’t have more time to write more clearly now.

41

“There are many things that can be done at the book level and I’ve posted on many of them in the past…”

Tom - I believe that everyone would use books if they were much smarter.

Steve

42

" I have seen studies of ‘ranking traders’ for 3,6 and 12 months go forward performance based on trailing period returns."

I believe for mutual funds, this strategy can be useful if you are betting on the fund manager. As soon as the fund gets a new manager, all bets are off. (Take Templeton for example.) Likewise, I believe the same can be said for R2G models. It is probably more useful to bet on the model designer, not the model itself. Same goes for “ranking traders”.

Steve

43

Okay. I decided to ‘play’ and added many factors to the various google doc list. They are all brainstorm factors.

44

My earlier comments regarding diversification were regarding an equity portfolio of individual securities, which I view as P123’s core competency. It would be nice if P123 expanded its capabilities to better evaluate multi-asset class portfolios, but I didn’t think that was within scope of the original post. As I mentioned earlier, I use other tools for broad asset allocation, and P123 for equity security selection. I found evaluating ETFs on P123 to be difficult because there’s no information on fundamental factors (e.g., valuation, yield).

Regarding books, I like Tom’s suggestion to include book-level constraints on sectors, market caps, and beta. Improved support for long-short books would also be helpful.

1 Like
45

Using the 80/20 rule, perhaps 3 uncorrelated portfolio’s would reduce risk by 64%. Perhaps echoing what Tom said, in my experience, nothing reduces risk more than diversification among uncorrelated assets/strategies. The problem is to find good uncorrelated strategies to diversify into. Long stock portfolio’s will always have a fair amount of correlation. To truly reduce risk, I think, requires some different approaches.

46

Wow, lots of interesting things appeared in the Google doc! I have some questions . . .

Item: Presence of large positions as a % of daily trading volume by activist investors taking large positions in the stock and looking to ‘agitate’ for change

Question: While there is risk of decline if the agitator goes away, I suspect that most of the time, this is seen as an attraction, not a source of potential drawdown. In my experience, when there’s smoke, fire, if it isn’; there on day one, tends to follow eventually

Item: Senior Management issues - age of CEO (i.e. Buffett) or key players

Question: BRK is BRK, one in who knows how many. More often than not, however, this can be seen as a bullish situation, a special situation. It may spark a sale of the company, a major restructuring, or even simply fresh innovation from new blood. I think many investors would prefer to load up on situations like this if they feel hard times are coming, even to the point of paying a “death premium” in valuation.

Item: Industry wide Margin erosion; for example due to industry big dog trying to buy market share and put people out of business (i.e. the Amazon effect) - companies may be less stable when a giant market player is in their space

Reaction: May need to change that from margin erosion to ROE erosion. Margins are over-rated by journalists. If narrowing margins is accompanied by greater turnover, then the end result may be net positive (look at the history of technology)

Item: Collapse of a major industry ‘player’

Reaction: Could be bullish. Look, for example, at how the fall from the summit for the likes of AOL or MSFT played out. One giant gets hammered; losts of other companies flourish

Items: Earnings and/or Sales of Beta/Correlation to GDP and Earnings and/or Sales of Beta/Correlation to other companies in portfolio and other discussions involving, one way or another, correlation

Reaction: I’d be careful about doing too much with correlation. These things tend to be unstable over time and may bear some of the problems I expressed with share price histories; statistical report cards. In the economy and in businesses, correlations in general seem to be rising in many respects (likely relating to globalization) and I’m not sure new norms have yet been established. Notice that commodities, for example, are no longer widely seen as uncorrelated hedges against stocks. I would urge that no correlations be considered unless a non-quantiative explanation can be made for what we can expect of future correlations. Relying on purely statistical correlations could actually result in a dramatic increase in risk of disaster (besides leverage, I believe this was one of the LTCM problems and also was the bomb that blew up a lot of other hedge funds in the late 2000s).

Items: Sensitivity to Fama French Factors and Sensitivity to Barra (or similar) equity factors

Reaction: Maybe I’ve had too long a day; I’m not sure what these are getting at.